1. TexMex Products is considering a new salsa whose data are shown below. The equipment that would be used would be depreciated by the straight-line method over its 3-year life, would have zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)
WACC 10.0%
Pre-tax cash flow reduction in other products (cannibalization) $5,000
Investment cost (depr'ble basis) $65,000
Straight-line depr'n rate 33.333%
Sales revenues, each year $75,000
Annual operating costs, ex. depr'n $25,000
Tax rate 35.0%
To calculate the Net Present Value (NPV) of the project, we need to discount the cash flows using the Weighted Average Cost of Capital (WACC). Here are the steps to calculate the NPV:
1. Calculate the annual cash flows for each year of the project:
- Revenue: $75,000
- Operating costs (excluding depreciation): $25,000
- Depreciation expense: Depreciable basis * Depreciation rate = $65,000 * 33.333% = $21,666.65
- Pre-tax cash flow reduction in other products (cannibalization): -$5,000 (negative because it reduces cash flows)
- Taxable income: Revenue - Operating costs - Depreciation expense - Pre-tax cash flow reduction = $75,000 - $25,000 - $21,666.65 - $5,000 = $23,333.35
- Taxes: Taxable income * Tax rate = $23,333.35 * 35% = $8,166.67
- Cash flows after tax: Revenue - Operating costs - Taxes = $75,000 - $25,000 - $8,166.67 = $41,833.33
2. Calculate the discount factor for each year using the WACC:
- Discount factor = 1 / (1 + WACC)^n, where n is the year
Year 1: Discount factor = 1 / (1 + 10%)^1 = 0.9091
Year 2: Discount factor = 1 / (1 + 10%)^2 = 0.8264
Year 3: Discount factor = 1 / (1 + 10%)^3 = 0.7513
3. Calculate the discounted cash flow for each year by multiplying the cash flow after tax by the discount factor:
Year 1: Discounted cash flow = $41,833.33 * 0.9091 = $38,030.30
Year 2: Discounted cash flow = $41,833.33 * 0.8264 = $34,520.00
Year 3: Discounted cash flow = $41,833.33 * 0.7513 = $31,446.67
4. Calculate the NPV by summing up all the discounted cash flows and subtracting the initial investment cost:
NPV = Sum of discounted cash flows - Initial investment cost
= $38,030.30 + $34,520.00 + $31,446.67 - $65,000
= $38,997.97
Therefore, the project's NPV is $38,997.97.
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