Deer Valley Lodge, a ski resort in the Wasatch Mountains of Utah, has plans to eventually add five new chair lifts. Suppose that one lift costs $2 million, and preparing the slope and installing the lift costs another $1.3 million. The lift will allow 300 additional skiers on the slopes, but there are only 40 days a year when the extra capacity will be needed, (Assume that Deer park will sell all 300 lift tickets on those 40 days.) Running that new lift will cost $500 a day for the entire 200 days the lodge is open. Assume that the lift tickets at Deer Valley cost $55 a day and the added cash expenses for each skier-day are $5. The new lift has an economic life of 20 year.
1.What if the before-tax required rate of return for Deer Valley is 14%. Compute the before tax NPV of the new lift and advise the managers of Deer Valley about adding the lift to be a profitable investment
2. What if the after-tax required rate of return for Deer Valley is 8% the income tax rate is 40%, and the MACRS recovery period is 10 years. Compute the after-tax NPV of the new lift and advise the managers of Deer Valley about adding the lift will be profitable investment.
3. What subjective factors would affect the investment decision?
To compute the before-tax NPV and after-tax NPV of the new lift, we need to calculate the cash flows associated with the project and discount them accordingly.
1. Before-tax NPV:
To calculate the before-tax NPV of the new lift, we need to determine the cash flows and discount them at the required rate of return.
a) Initial investment:
The initial investment for the lift includes the cost of the lift itself ($2 million) and the cost of preparing the slope and installing the lift ($1.3 million). Therefore, the initial investment is $2 million + $1.3 million = $3.3 million.
b) Additional annual revenues:
The lift will allow 300 additional skiers on the slopes for 40 days a year. Therefore, the additional annual revenues are:
300 skiers/day * $55 ticket price/day * 40 days = $660,000.
c) Additional annual cash expenses:
The additional annual cash expenses are related to running the new lift and amount to $500/day * 200 days = $100,000.
d) Salvage value:
The salvage value refers to the value of the lift at the end of its economic life, which is 20 years. Assuming no salvage value, it is considered to be $0.
Now, we can calculate the before-tax NPV using the formula:
NPV = -Initial investment + (Annual cash flows / (1 + Required rate of return)^n)
Where n represents the year.
In this case, the required rate of return is 14% (0.14), and we need to calculate the NPV for each year from 1 to 20.
To calculate the NPV for each year, subtract the annual cash expenses from the additional annual revenues. Then discount the resulting cash flow using the required rate of return. Finally, sum up all the discounted cash flows.
After calculating the NPV for each year, sum them up to get the total before-tax NPV.
2. After-tax NPV:
To calculate the after-tax NPV of the new lift, we need to consider the effects of income taxes and the MACRS recovery period.
The MACRS recovery period is 10 years, meaning the lift will be depreciated over this period. For simplicity, assume equal depreciation expenses each year.
To calculate the annual depreciation expense, divide the initial investment ($3.3 million) by the recovery period (10 years), resulting in $330,000.
Next, we calculate the taxable income, which is the difference between the additional annual revenues and the additional annual cash expenses minus the depreciation expense.
Taxable income = Additional annual revenues - Additional annual cash expenses - Depreciation expense
After obtaining the taxable income, calculate the tax expense by multiplying it by the income tax rate of 40%.
Tax expense = Taxable income * Income tax rate
Finally, calculate the after-tax cash flows by subtracting the tax expense from the taxable income. Then, discount these cash flows using the after-tax required rate of return of 8%.
Using the same formula as above, we can calculate the after-tax NPV for each year and sum them up to obtain the total after-tax NPV.
3. Subjective factors:
In addition to the quantitative analysis of the NPV, there are also subjective factors that could affect the investment decision. These factors include:
- Competitive analysis: Assessing the potential impact of adding the new lift on competitor resorts in the area.
- Market demand: Evaluating the current and projected demand for skiing in the area and estimating the potential market growth.
- Weather conditions: Considering the reliability of snowfall in the region and the potential impact of climate change on ski resort operations.
- Customer preferences: Understanding the preferences and needs of the target market and ensuring that the new lift aligns with their expectations.
- Maintenance and operational considerations: Evaluating the ongoing costs of maintaining and operating the new lift, including staffing, repairs, and maintenance.
- Long-term strategic goals: Analyzing how the addition of the new lift aligns with the long-term strategic goals of Deer Valley Lodge.
- Environmental impact: Assessing any potential environmental consequences of adding the lift and considering how it aligns with sustainability practices.
Considering both the financial analysis (NPV) and these subjective factors will provide a comprehensive view when advising the managers of Deer Valley Lodge about the profitability of adding the new lift.