3. Company A plans to undertake a project that requires an investment of $1 bill

Question

3. Company A plans to undertake a project that requires an investment of $1 billion. The project will generate the following annual risky earnings stream (before depreciation and taxes). Assume that the project has a five year life. $132 million with a 0.5 chance $532 million with a 0.5 chance The firm is allowed to depreciate the asset in equal installments over its five year life. The tax rate is 34%. For simplicity, assume: (i) a zero discount rate; (ii) that losses cannot be carried back or forward a) Calculate the expected annual earnings before depreciation and taxes

b) Calculate the expected annual tax liability

c) Calculate the expected NPV and determine if the firm should or should not invest in the capital asset in question.

d) Assume that the firm can hedge its earnings and thereby fix them at the level of expected earnings in “a)”. How does this hedging affect the firm’s expected tax liability and the expected NPV of the investment?

Explanation / Answer

(a) Expected annual earning before depreciation and taxes = ($132 x 0.50 + $532 x 0.50) Million = $332 Million

(b) Expected annual tax Liability = (Total Earning - Depreciation allowed) x 34%

= $332 - ($1000/5) x 34% = ($332 - $200) x 34% = $44.88 million

(c) Calculation of Expected NPV

Since there is positive NPV, company A should Invest.

(d) Hedging means a process of takina a opposite position in order to reduce loss caused by price fluctuation. The objective of hedging is to reduce loss. In the present case the company is not incurring any loss so in my openion there is no need to hedge.

If firm can hedge its earning and thereby fix them at the level of expected earning in "a" it does not affect the tax liability and expected NPV as these both are calculated as assuming the earning same as in "a" above.

Year Annual earning before tax ($) Tax @ 34%($) Annual Earning after tax($) Depreciation ($) Cash Flow after tax ($) 1 132 44.88 87.12 200 287.12 2 132 44.88 87.12 200 287.12 3 132 44.88 87.12 200 287.12 4 132 44.88 87.12 200 287.12 5 132 44.88 87.12 200 287.12 TOTAL 1435.60 Initial Investment 1000.00 NPV 435.60 Desition Invest

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