What is the relevant net income for year 1 of project A that Middlefield Motors

ID: 2730340 • Letter: W

Question

What is the relevant net income for year 1 of project A that Middlefield Motors should use in its NPV analysis of the project? The tax rate is 10 percent. During year 1, the project A is expected to have relevant revenue of 77,000 dollars, relevant variable costs of 11,000 dollars, and relevant depreciation of 13,000 dollars. In addition, Middlefield Motors would have one source of fixed costs associated with the project A. Yesterday, Middlefield Motors signed a deal with Creative Advertising to develop a marketing campaign. The terms of the deal require Middlefield Motors to pay Creative Advertising either 23,000 dollars in 1 year if project A is pursued or 15,000 dollars in 1 year if project A is not pursued.

Explanation / Answer

If Project A is pursued:- Payment made to creative advertising = $ 23000.

Sales

(-) Variable costs

77000

11000

Contribution

(-) Fixed Costs (Note 1)

66000

36000

Operating income

(-) Tax @ 10%

30000

3000

(NOTE 1):- Fixed cost = Depreciation + Payment to creative advertising (assuming it is tax deductible)

= 13000 + 23000

= $ 36000

Conclusion:- The relevant net income for year 1 of project A = $ 27000.

(NOTE 2):- While calculating NPV of project A, depreciation of $ 13000 should be added to net income of $ 27000 to arrive at operating cash flow (OCF) and then discount this OCF with cost of capital / required rate of return.