TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a 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 for other products (cannibalization)
-$5,000
Investment cost (depreciable basis)
$80,000
Straight-line depr. rate
33.333%
Sales revenues, each year for 3 years
$63,500
Annual operating costs (excl. depr.)
-$25,000
Tax rate
35.0%
The answer i chose was - 2,612 but i have a feeling it was wrong and if it rights it was by chance.It doesn't feel like I got it the right way . Need help
the WACC 10%
Pre-tax cash flow reduction for other products (cannibalization) -5000
Investment cost (depreciable basis) 80,000
Straight-line depr. rate 33.333%
Sales revenues, each year for 3 year 63,500
Annual operating costs(excl. depr.)-25,000
Tax rate 35.0%
To calculate the project's Net Present Value (NPV), you need to consider the cash flows associated with the project and discount them to their present value using the Weighted Average Cost of Capital (WACC). Let's break down the steps to determine the project's NPV:
Step 1: Calculate the annual depreciation expense.
Given that the equipment has a depreciable basis of $80,000 and a straight-line depreciation rate of 33.333% (equivalent to 100% divided by 3 years), we can calculate the annual depreciation expense as follows:
Annual depreciation expense = Depreciable basis * Straight-line depreciation rate = $80,000 * 33.333% = $26,667
Step 2: Calculate the annual pre-tax cash flows.
The pre-tax cash flows would be the sales revenues minus the operating costs (excluding depreciation) and the cash flow reduction due to cannibalization:
Annual pre-tax cash flows = Sales revenues - Operating costs (excluding depreciation) - Cannibalization impact
= $63,500 - $25,000 - $5,000 (per year)
= $33,500
Step 3: Calculate the annual after-tax cash flows.
To calculate the after-tax cash flows, we need to account for the tax rate. The after-tax cash flow would be (1 - Tax rate) multiplied by the annual pre-tax cash flow:
Annual after-tax cash flows = (1 - Tax rate) * Annual pre-tax cash flow
= (1 - 35%) * $33,500
= $21,775
Step 4: Discount the annual after-tax cash flows to their present value.
To discount the cash flows, we will use the WACC, which is given as 10%. Discounting is done by dividing the annual cash flows by the discount rate (1 + WACC) raised to the power of the respective year:
Year 1: Present value = Annual after-tax cash flow / (1 + WACC)^1 = $21,775 / (1 + 10%)^1 = $19,795
Year 2: Present value = Annual after-tax cash flow / (1 + WACC)^2 = $21,775 / (1 + 10%)^2 = $17,995
Year 3: Present value = Annual after-tax cash flow / (1 + WACC)^3 = $21,775 / (1 + 10%)^3 = $16,359
Step 5: Calculate the project's NPV.
The NPV of the project is the sum of the present values of the cash flows minus the initial investment cost:
NPV = Sum of Present Values - Initial investment cost
= ($19,795 + $17,995 + $16,359) - $80,000
= $54,149 - $80,000
= -$25,851
Therefore, the correct NPV for the project is -$25,851. It appears that your initial answer of -$2,612 was incorrect.