Question

1. You have the following information to evaluate a project and make a decision whether you should accept the project:

Purchase price = $120,000 (20 year life, straight-line depreciation, zero salvage value).

Operating expenses will decrease from $30,000 to $20,000.

Revenue will increase from $50,000 to $57,000.

Marginal tax rate = 40%

Risk-free rate = 2.5%

Return on the market = 5.5%

Beta = 1.5

             

Should you accept this project? Why?

Answer 1

We will accept the project if the NPV is positive.

NPV = PV of cash inflows - Pv of cash outflows

PV OF CASH INFLOWS

Decrease in operating expenses is a saving hence a inflow which is = 30000 - 20000 = 10000

Increase in revenue is a inflow = 57000 - 50000 = 7000

Depreciation each year = cost / life = 120000 / 20 = 6000

Cash flows each year = (inflows - depreciation )* (1 - tax rate ) + depreciation  

= (10000 +7000 - 6000) * (1 -0.4) + 6000

=6600 + 6000

=12600

Pv of cash inflows = cash flows / expected rate of return

Expected rate of return as per CAPM ,

ER= Rf + ( Rm - Rf) * B

Rf= Risk free rate = 2.5 , Rm = Retrun on market = 5.5, B = Beta

= 2.5 + ( 5.5 - 2.5 ) *1.5

= 7%

Pv of cash inflows = 12600 /0.07

=180000

Pv of cash outflows = cost of project = 120000

NPV = 180000 - 120000 = $60,000

The NPV is positive hence we should accept the project.