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Analysis of an expansion project Companies invest in expansion projects with the expectation of increasing the earnings of its business

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Analysis of an expansion project

Companies invest in expansion projects with the expectation of increasing the earnings of its business.

Consider the case of Fox Co.:

Fox Co. is considering an investment that will have the following sales, variable costs, and fixed operating costs:

	Year 1	Year 2	Year 3	Year 4
Unit sales	4,200	4,100	4,300	4,400
Sales price	$29.82	$30.00	$30.31	$33.19
Variable cost per unit	$12.15	$13.45	$14.02	$14.55
Fixed operating costs	$41,000	$41,670	$41,890	$40,100

This project will require an investment of $25,000 in new equipment. Under the new tax law, the equipment is eligible for 100% bonus deprecation at t = 0, so it will be fully depreciated at the time of purchase. The equipment will have no salvage value at the end of the project’s four-year life. Fox pays a constant tax rate of 25%, and it has a weighted average cost of capital (WACC) of 11%. Determine what the project’s net present value (NPV) would be under the new tax law.

Determine what the project’s net present value (NPV) would be under the new tax law.

$44,626

$55,782

$64,149

$50,204

Now determine what the project’s NPV would be when using straight-line depreciation. $54,378

Using the straight-line depreciation method will result in the highest NPV for the project.

No other firm would take on this project if Fox turns it down. How much should Fox reduce the NPV of this project if it discovered that this project would reduce one of its division’s net after-tax cash flows by $700 for each year of the four-year project?

$1,629

$2,172

$1,846

$1,303

Fox spent $1,750 on a marketing study to estimate the number of units that it can sell each year. What should Fox do to take this information into account?

Increase the NPV of the project $1,750.

Increase the amount of the initial investment by $1,750.

The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost.