you work as a financial analyst for Athens development corporation. You work as
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Question
you work as a financial analyst for Athens development corporation. You work as a financial analyst for Athens Development Corporation. The company is considering a new capital investment that is sensitive to the economic conditions as well as consumer demand. The new capital investment requires an initial outlay of $150, 000 to buy a machine. The machine will be depreciated over 3 years with straight line depreciation method. The salvage value of the machine after three years will be zero. In the first year, it will provide annual revenue of $45,000 and annual expense of $20, 000 with a probability of .7 if the demand is good or the revenue will be only $25,000 and the expense is $20, 000 with a probability of 0.3 if the demand is low. If the demand is good in the first year, then the project is expected to bring annual revenue of $45,000 and annual expense of $20, 000 indefinitely. But if the demand is low in the first year, the company will stop making the new product and sell the machine for $50, 000 at the end of the first year. The tax rate is 30% and the before tax cost of debt is 10%. The weighted average cost of capital is 15%. Should the company make the new investment?Explanation / Answer
Athens Development Corporation All Amounts in $ To understand whether the Company should make the new investment or not, we need to evaluate the Net Present Value or NPV in two scenarios Scenario I : Demand is good in the first year Probability is 0.7 Hence, Cash Inflows for Years 1 to 3 will be Year Revenue Expenses Interest Depreciation Net Income Income Cash Flows on Investment E Post Tax G A B C D A-B-C-D F F + D + C 1 31500 14000 15000 50000 -47500 -33250 31750 2 31500 14000 15000 50000 -47500 -33250 31750 3 31500 14000 15000 50000 -47500 -33250 31750 The Cost of Capital is 15% With this information, the NPV works out to -$ 67,397.92 Scenario I : Demand is good in the first year Probability is 0.3 The Cash Flows in the first year will be ((25,000 - 20,000) X 0.3 - 15,000 - 50,000) X 0.7 + 50,000 + 15,000 = 20550 $ The salvage value of the machine at the end of the first year in this case will be $ 50,000 The Cost of Capital is 15% With this information, the NPV works out to -$ 82,020.22 Since the NPV in both the cases is negative, hence the Company should not make the new investment.
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