/*! This file is auto-generated */ .wp-block-button__link{color:#fff;background-color:#32373c;border-radius:9999px;box-shadow:none;text-decoration:none;padding:calc(.667em + 2px) calc(1.333em + 2px);font-size:1.125em}.wp-block-file__button{background:#32373c;color:#fff;text-decoration:none} Problem 9 Calculating NPV Howell Petroleum... [FREE SOLUTION] | 91影视

91影视

Log out

Learning Materials

Features

Discover

Chapter 6: Problem 9

Calculating NPV Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs \(\$ 1.8\) million. The marketing department predicts that sales related to the project will be \(\$ 1.1\) million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its fouryear economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. Howell also needs to add net working capital of \(\$ 150,000\) immediately. The additional net working capital will be recovered in full at the end of the project's life. The corporate tax rate is 35 percent. The required rate of return for Howell is 16 percent. Should Howell proceed with the project?

Short Answer

Expert verified
The NPV of the project is -\$0.57675 million, which is negative. Therefore, it is not advisable for Howell Petroleum to proceed with the project, as it would result in a loss.

Step by step solution

01

Compute yearly cash flows

First, we need to find the yearly cash flows from the project. To do this, we will calculate the revenue, cost of goods sold, operating expenses, and depreciation, and then subtract the costs from the revenue. 1. Revenue: \(1.1\) million per year for four years. 2. Cost of goods sold and operating expenses: 25% of sales or \(0.275\) million (\(1.1\text{ million} \times 0.25\)). 3. Depreciation: The machine costs \(\$1.8\) million and will be depreciated over its four-year life on a straight-line basis, which results in a depreciation of \(0.45\) million per year (\(1.8\text{ million} 梅 4\)). Now we will calculate the yearly cash flows: Yearly Cash Flows = Revenue - Cost of goods sold & operating expenses - Depreciation Yearly Cash Flows = \(1.1\text{ million} - 0.275\text{ million} - 0.45\text{ million} = \$0.375\text{ million}\)
02

Determine after-tax cash flow

To determine the after-tax cash flow, we need to find the tax payment for each year and subtract it from the yearly cash flows. Tax Payment = (Yearly Cash Flows - Depreciation) 脳 Corporate Tax Rate Tax Payment = (\(0.375\text{ million} - 0.45\text{ million}) 脳 0.35 = -\$0.02625\text{ million}\) After-Tax Cash Flow = Yearly Cash Flows - Tax Payment After-Tax Cash Flow = \(0.375\text{ million} - (-0.02625\text{ million}) = \$0.40125\text{ million}\)
03

Calculate the NPV of the project

Now we will calculate the NPV of the project using the following formula: NPV = Initial Investment + \[ \sum_{i=1}^{n} \frac{After-Tax Cash Flow}{(1 + Required Rate of Return)^i} \] - Final Net Working Capital Recovery Where n is the number of years. Initial Investment = -\(1.8\text{ million} - 0.15\text{ million} = -\$1.95\text{ million}\) Required Rate of Return = 16% (or 0.16) Final Net Working Capital Recovery = \(0.15\text{ million}\) (since it is recovered in full) NPV = -\(1.95\text{ million} + \[ \sum_{i=1}^{4} \frac{0.40125\text{ million}}{(1 + 0.16)^i} \] - 0.15\text{ million}\) Calculate each individual term in the sum: \(\frac{0.40125\text{ million}}{(1 + 0.16)^1} = 0.34591\text{ million}\) \(\frac{0.40125\text{ million}}{(1 + 0.16)^2} = 0.29819\text{ million}\) \(\frac{0.40125\text{ million}}{(1 + 0.16)^3} = 0.25723\text{ million}\) \(\frac{0.40125\text{ million}}{(1 + 0.16)^4} = 0.22193\text{ million}\) Now we can add these up and calculate the NPV: NPV = -\(1.95\text{ million} + (0.34591 + 0.29819 + 0.25723 + 0.22193)\text{ million} - 0.15\text{ million} = -\$0.57675\text{ million}\)
04

Make a decision based on the computed NPV

Since the NPV is -\(0.57675\text{ million}\) (which is negative), it is not advisable for Howell Petroleum to proceed with the project, as it would result in a loss.

Unlock Step-by-Step Solutions & Ace Your Exams!

  • Full Textbook Solutions

    Get detailed explanations and key concepts

  • Unlimited Al creation

    Al flashcards, explanations, exams and more...

  • Ads-free access

    To over 500 millions flashcards

  • Money-back guarantee

    We refund you if you fail your exam.

Over 30 million students worldwide already upgrade their learning with 91影视!

Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Capital Budgeting
Capital budgeting is the process businesses use to evaluate potential major projects or investments. The objective is to determine the expected future cash flows of a project and assess whether the project will yield profits that exceed its costs. There are multiple techniques to decide on these investments. A popular method is Net Present Value (NPV), an indicator of how much value an investment or project adds to a company.

The core steps in capital budgeting include:
  • Identifying potential investments or projects.
  • Estimating future cash flows for these projects.
  • Calculating the present value of expected cash flows using a required rate of return.
  • Making decisions based on the present value calculation.
Considerations in these decisions often include the scale of the investment, the duration of costs and returns, and the associated risks, balancing the potential benefits with the potential costs.
Depreciation
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life. Essentially, it reflects the asset's consumption or use, allowing companies to offset their costs through calculated deductions on their financial statements. This systematic allocation is crucial in providing a more accurate financial picture for both reporting purposes and investment decision-making.

Straight-line depreciation, used in this exercise, is the simplest depreciation method. It involves declining an asset's value evenly over its useful life. For Howell Petroleum's project, the machine's \(\\(1.8\) million cost is depreciated at \(\\)0.45\) million per year over four years. Depreciation affects a project's cash flow through tax benefits, as it reduces taxable income, billing only the actual cash outlay before taxes. Thus, accurate depreciation calculations can significantly impact investment evaluations in capital budgeting.
Corporate Tax Rate
The corporate tax rate is the tax imposed on a company's taxable income. It is an essential consideration in project evaluations as it affects the project鈥檚 net cash flows and, consequently, its viability. Taxes reduce a company's income, which means understanding the actual tax burden is crucial for accurate financial projections.

In capital budgeting exercises like Howell's, tax calculations determine how much money the project will retain after statuary deductions. Here, a 35% corporate tax rate applies. The tax payment is derived from adjusted pre-tax cash flows, which are reduced by depreciation. The resulting after-tax cash flow is then used to determine NPV. Understanding the impact of the corporate tax rate helps in reflecting true profitability and avoiding financial missteps in decision-making.
Required Rate of Return
The required rate of return represents the minimum return an investor expects to achieve by investing in a project, given its risk level. It's an essential benchmark in capital budgeting that helps determine whether a project meets an investor's financial objectives.

This rate, often derived from the company's cost of capital or a risk-adjusted rate, acts as the discount rate in NPV calculations. For Howell Petroleum, this rate is 16%. The rate of return accounts for the time value of money鈥攈ighlighting that funds received in the future are worth less than those received today. Calculating NPV involves discounting future cash flows using this rate. When the NPV is positive, the investment is generally considered favorable because it exceeds the required rate. In contrast, a negative NPV, as found in this case, indicates that the project does not cover the cost of capital, signaling a potential loss.

One App. One Place for Learning.

All the tools & learning materials you need for study success - in one app.

Get started for free

Most popular questions from this chapter

Project Analysis and Inflation Dickinson Brothers, Inc., is considering investing in a machine to produce computer keyboards. The price of the machine will be \(\$ 530,000\), and its economic life is five years. The machine will be fully depreciated by the straight-line method. The machine will produce 15,000 keyboards each year. The price of each keyboard will be \(\$ 40\) in the first year and will increase by 5 percent per year. The production cost per keyboard will be \(\$ 20\) in the first year and will increase by 6 percent per year. The project will have an annual fixed cost of \(\$ 75,000\) and require an immediate investment of \(\$ \mathbf{2 5 , 0 0 0}\) in net working capital. The corporate tax rate for the company is 34 percent. If the appropriate discount rate is 15 percent, what is the NPV of the investment?

Comparing Mutually Exclusive Projects Hagar Industrial Systems Company (HISC) is trying to decide between two different conveyor belt systems. System A costs \(\$ 360,000\), has a four-year life, and requires \(\$ 105,000\) in pretax annual operating costs. System B costs \(\$ \mathbf{4 8 0 , 0 0 0}\), has a sixyear life, and requires \(\$ 65,000\) in pretax annual operating costs. Both systems are to be depreciated straight-line to zero over their lives and will have zero salvage value. Whichever system is chosen, it will not be replaced when it wears out. If the tax rate is 34 percent and the discount rate is 11 percent, which system should the firm choose?

Calculating Project NPV With the growing popularity of casual surf print clothing, two recent MBA graduates decided to broaden this casual surf concept to encompass a "surf lifestyle for the home." With limited capital, they decided to focus on surf print table and floor lamps to accent people's homes. They projected unit sales of these lamps to be 6,000 in the first year, with growth of 8 percent each year for the next five years. Production of these lamps will require \(\$ \mathbf{2 8 , 0 0 0}\) in net working capital to start. Total fixed costs are \(\$ 80,000\) per year, variable production costs are \(\$ 20\) per unit, and the units are priced at \(\$ 48\) each. The equipment needed to begin production will cost \(\$ 145,000\). The equipment will be depreciated using the straight-line method over a five-year life and is not expected to have a salvage value. The effective tax rate is 34 percent, and the required rate of return is 25 percent. What is the NPV of this project?

Comparing Mutually Exclusive Projects Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine \(A\) costs \(\$ \mathbf{\$ 2 , 4 0 0 , 0 0 0}\) and will last for six years. Variable costs are 35 percent of sales, and fixed costs are \(\$ 180,000\) per year. Machine B costs \(\mathbf{\$ 5 , 4 0 0 , 0 0 0}\) and will last for nine years. Variable costs for this machine are \(\mathbf{3 0}\) percent and fixed costs are \(\$ 110,000\) per year. The sales for each machine will be \(\$ 10.5\) million per year. The required return is 10 percent and the tax rate is 35 percent. Both machines will be depreciated on a straight-line basis. If the company plans to replace the machine when it wears out on a perpetual basis, which machine should you choose?

Project Analysis and Inflation Sanders Enterprises, Inc., has been considering the purchase of a new manufacturing facility for \(\$ 150,000\). The facility is to be fully depreciated on a straightline basis over seven years. It is expected to have no resale value after the seven years. Operating revenues from the facility are expected to be \(\$ 70,000\), in nominal terms, at the end of the first year. The revenues are expected to increase at the inflation rate of 5 percent. Production costs at the end of the first year will be \(\$ 20,000\), in nominal terms, and they are expected to increase at 6 percent per year. The real discount rate is 8 percent. The corporate tax rate is 34 percent. Sanders has other ongoing profitable operations. Should the company accept the project?
See all solutions

Recommended explanations on Math Textbooks

Discrete Mathematics

Read Explanation

Pure Maths

Read Explanation

Decision Maths

Read Explanation

Applied Mathematics

Read Explanation

Calculus

Read Explanation

Geometry

Read Explanation
View all explanations

What do you think about this solution?

We value your feedback to improve our textbook solutions.

Study anywhere. Anytime. Across all devices.