Question

Management of Group R Corporation is considering an expansion in the company’s product line that requires the purchase of an additional $185,000 in equipment with installation cost of $15,000 and removal expense of $5,000. The equipment and installation costs will be depreciated over five years using straight-line depreciation method. The expansion is expected to increase earnings before depreciation and taxes as follows:

Year 1         $60,000

Year 2        $60,000

Year 3        $75,000

Year 4        $75,000

Year 5        $50,000

Group R Corporation’s income tax rate is 20 percent, and the weighted average cost of capital is 10 percent. Because of uncertainty in the market, the company’s financial analyst predicts that the likelihood that the worst-case scenario happening is 20%; and the likelihood of the best-case scenario occurring is 30%. Based upon the net present value method of capital budgeting should management undertake this project?

Answer 1

Statement showing NPV

Particulars	0	1	2	3	4	5	NPV = Sum of PV
Purchase cost of equipment	-185000
Instalation cost	-15000
Removal expense	-5000
Increased EBIT		60000	60000	75000	75000	50000
Depreciation((185000+15000)/5) =200000/5 =40000 pa		40000	40000	40000	40000	40000
PBT		20000	20000	35000	35000	10000
Tax rate @ 20%		4000	4000	7000	7000	2000
PAT		16000	16000	28000	28000	8000
Add: Depreciation		40000	40000	40000	40000	40000
Cash flow		56000	56000	68000	68000	48000
Total cash flow	-205000	56000	56000	68000	68000	48000
PVIF @ 10%	1	0.9091	0.8264	0.7513	0.683	0.6209
PV (Total cash flow*PVIF)	-205000	50909.09	46280.99	51089.41	46444.91	29804.22	19528.63

Since NPV is positive management should take up the project