Question

25.

Red Royal Banking is evaluating the medical clinic project, a 2-year project that would involve buying equipment for 66,000 dollars that would be depreciated to zero over 2 years using straight-line depreciation. Cash flows from capital spending would be $0 in year 1 and 8,000 dollars in year 2. Relevant annual revenues are expected to be 108,000 dollars in year 1 and 108,000 dollars in year 2. Relevant expected annual variable costs from the project are expected to be 18,000 dollars in year 1 and 18,000 dollars in year 2. Finally, the firm has no fixed costs in year 1 and one fixed cost in year 2 of the project. Yesterday, Red Royal Banking signed a deal with Orange Valley Consulting to develop an advertising campaign. The terms of the deal require Red Royal Banking to pay Orange Valley Consulting either 69,000 dollars in 2 years from today if the medical clinic project is pursued or 44,000 dollars in 2 years from today if the medical clinic project is not pursued. The tax rate is 10 percent and the cost of capital for the medical clinic project is 6.26 percent. What is the net present value of the medical clinic project?

Answer 1

Net present value of the medical clinic project is present value of all future cash flows. (Amount in $)

Equipment cost = 66,000 Life = 2 Years Depreciation = 66,000/2 = 33,000 p.a.

Tax Saving on depreciation 33,000*10% = 3,300

Tax Rate 10% Cost of capital 6.26%

Year	Cash Flows (a)	Annual Revenue (b)	Annual Variable Cost (After tax) (c)	Advertisement (After tax) (d)	Tax Saving on Depreciation (e)	Net Cashflow (a)+(b)+(c)+(d)+(e) = (f)	Present value Factors (6.26%) (g)	Amount (f)*(g)
0	(66,000)	-	-	-	-	(66,000)	1	(66,000)
1	0	108,000	(16,200)	-	3300	95,100	0.9411	89,405
2	8,000	108,000	(16,200)	(62,100)	3300	41,000	0.8856	36,310
							NPV	59,715

The NPV of the project is $ 59,715

Since NPV of the clinical project is positive , Red Royal Banking should accept the project.