Companies invest in expansion projects with the expectation of increasing the earnings of its business.
Consider the case of Pheasant Pharmaceuticals:
Pheasant Pharmaceuticals is considering an investment that will have the following sales, variable costs, and fixed operating costs:
| Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|
| Unit sales (units) | 4,200 | 4,100 | 4,300 | 4,400 |
| Sales price | $29.82 | $30.00 | $30.31 | $33.19 |
| Variable cost per unit | $12.15 | $13.45 | $14.02 | $14.55 |
| Fixed operating costs except depreciation | $41,000 | $41,670 | $41,890 | $40,100 |
| Accelerated depreciation rate | 33% | 45% | 15% | 7% |
This project will require an investment of $15,000 in new equipment. The equipment will have no salvage value at the end of the project’s four-year life. Pheasant Pharmaceuticals pays a constant tax rate of 40%, and it has a required rate of return of 11%.
When using accelerated depreciation, the project’s net present value (NPV) is . (Hint: Round each element in your computation—including the project’s net present value—to the nearest whole dollar.)
When using straight-line depreciation, the project’s NPV is . (Hint: Again, round each element in your computation—including the project’s net present value—to the nearest whole dollar.)
Using the depreciation method will result in the greater NPV for the project.
No other firm would take on this project if Pheasant Pharmaceuticals turns it down. How much should Pheasant Pharmaceuticals reduce the NPV of this project if it discovered that this project would reduce one of its division’s net after-tax cash flows by $300 for each year of the four-year project?
$1,024$559$791$931
