What’s Wrong with this Picture? In the following discussion, see how many errors
ID: 2732648 • Letter: W
Question
What’s Wrong with this Picture?
In the following discussion, see how many errors you can spot and explain briefly why each is an error. You do not need to correct the error.
“Loretta, I think we’ve got a winner here. Take a look at these numbers!
Year
0
1
2
3
…
10
Initial cost
-1000 USD
Units sold
100
100
100
100
Price / unit
15
15
15
15
Total revenue
1500
1500
1500
1500
Cost of good sold
800
800
800
800
Gross profit
700
700
700
700
Operating exepnses
depreciation
100
100
100
100
Interesty expesnes
100
100
100
100
Income before tax
500
500
500
500
Tax 40%
200
200
200
200
Income after tax
300
300
300
300
“Now, Loretta, here’s how I figure it: The boss says our corporate goal should be to increase earnings by at least 15 percent every year, and this
project certainly increases earnings. It adds $300,000 to income after tax every year.
“My trusty calculator tells me that the rate of return on this project is 30 percent ($300/$1,000), well above our minimum target return of 10 percent. And if you want to use net present value, its NPV dis- counted at 10 percent is $843.50.”
“So, what do you think, Loretta?” “Well, Denny, it looks pretty good, but I do have a few questions.” “Shoot, Loretta” “OK. What about increases in accounts receivable and stuff like that?”
“Not relevant! We’ll get that money back when the project terminates, so it’s equivalent to an interest-free loan, which is more of a benefit than a cost.”
“But, Denny, what about extra selling and administrative costs? Haven’t you left those out?”
“That’s the beauty of this, Loretta. Given the recent recession, I figure we can handle the added business with existing personnel. In fact, one of the virtues of the proposal is that we should be able to retain some people we would otherwise have to terminate.”
“Well, you’ve convinced me, Denny. Now, I think it will be only fair if the boss puts you in charge of this exciting new project.”
Year
0
1
2
3
…
10
Initial cost
-1000 USD
Units sold
100
100
100
100
Price / unit
15
15
15
15
Total revenue
1500
1500
1500
1500
Cost of good sold
800
800
800
800
Gross profit
700
700
700
700
Operating exepnses
depreciation
100
100
100
100
Interesty expesnes
100
100
100
100
Income before tax
500
500
500
500
Tax 40%
200
200
200
200
Income after tax
300
300
300
300
Explanation / Answer
The NPV of the project is much higher than it is predicted. the correct NPV is $ 1,457.82. This is because the Depreciation has to be added back to the income after tax to arrive at the cashflow which has to be discounted over 10 years to arrive at the NPV.
Year 0 1 to 10 Initial cost -1000 Units sold 100 Price / unit 15 Total revenue 1500 Cost of good sold 800 Gross profit 700 Operating exepnses depreciation 100 Interest expneses 100 Income before tax 500 Tax 40% 200 Income after tax 300 Add: Depreciation 100 Cashflow 400 PVAF( 10%, 10 yrs) 6.14456 PV of cashflow 2,457.82 NPV 1,457.82Related Questions
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