Better Mousetraps has developed a new trap. It can go into production for an ini

Question

Better Mousetraps has developed a new trap. It can go into production for an initial investment in equipment of $5.4 million. The equipment will be depreciated straight line over 6 years to a value of zero, but in fact it can be sold after 6 years for $584,000. The firm believes that working capital at each date must be maintained at a level of 10% of next year’s forecast sales. The firm estimates production costs equal to $1.30 per trap and believes that the traps can be sold for $5 each. Sales forecasts are given in the following table. The project will come to an end in 6 years, when the trap becomes technologically obsolete. The firm’s tax bracket is 35%, and the required rate of return on the project is 10%. Use the MACRS depreciation schedule.

a. What is project NPV? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in millions rounded to 4 decimal places.)

b. By how much would NPV increase if the firm depreciated its investment using the 5-year MACRS schedule? (Do not round intermediate calculations. Enter your answer in whole dollars not in millions.)

Year: 0 1 2 3 4 5 6 Thereafter Sales (millions of traps) 0 0.6 0.7 0.8 0.8 0.7 0.4 0

Explanation / Answer

NPV @ 10% = $3,090,721 = $3.0907 million

As the book value at the end of 6th year is zero in both cases, tax on capital gain on both cases is same: (MV - BV)*Tax. Therefore, this is ignored while moving from straight line to MACRS depreciation.

When depreciation method 5-year MACRS instead of straight line is used, NPV will increase by $89,555

Investment 0 1 2 3 4 5 6 Initial investment -5,400,000 A Depreciation 900,000 900,000 900,000 900,000 900,000 900,000 Tax saving on depreciation @ 35% 315,000 315,000 315,000 315,000 315,000 315,000 B Book Value 0 Market Value 584,000 After-tax MV = MV-(MV-BV)*Tax 379,600 C Working Capital (PQ*10%) -300,000 -350,000 -400,000 -400,000 -350,000 -200,000 0 Net change in WC -300,000 -50,000 -50,000 0 50,000 150,000 200,000 D Cash Flow (X) -5,700,000 265,000 265,000 315,000 365,000 465,000 894,600 sum A to D Operation Units sold (Q) 600,000 700,000 800,000 800,000 700,000 400,000 Sales per unit (P) 5 5 5 5 5 5 Cost per Unit (C) 1.30 1.30 1.30 1.30 1.30 1.30 Gross Profit = (P - C)Q 2,220,000 2,590,000 2,960,000 2,960,000 2,590,000 1,480,000 Tax -777,000 -906,500 -1,036,000 -1,036,000 -906,500 -518,000 Cash Flow (Y) 1,443,000 1,683,500 1,924,000 1,924,000 1,683,500 962,000 FCF (X + Y) -5,700,000 1,708,000 1,948,500 2,239,000 2,289,000 2,148,500 1,856,600 NPV @ 10% 3,090,721

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