3. Analysis of an expansion project

Companies invest in expansion projects with the expectation of increasing the earnings of its business.

Consider the case of Yeatman Co.:

Yeatman Co. 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	5,500	5,200	5,700	5,820
Sales price	$42.57	$43.55	$44.76	$46.79
Variable cost per unit	$22.83	$22.97	$23.45	$23.87
Fixed operating costs	$66,750	$68,950	$69,690	$68,900

This project will require an investment of $15,000 in new equipment. Under the new tax law, the equipment is eligible for 100% bonus deprecation at t = 0, so it will be fully depreciated at the time of purchase. The equipment will have no salvage value at the end of the projects four-year life. Yeatman pays a constant tax rate of 25%, and it has a weighted average cost of capital (WACC) of 11%. Determine what the projects net present value (NPV) would be under the new tax law.

Determine what the projects net present value (NPV) would be under the new tax law.

$120,523

$100,436

$80,349

$90,392

Now determine what the projects NPV would be when using straight-line depreciation.

Using the depreciation method will result in the highest NPV for the project.

No other firm would take on this project if Yeatman turns it down. How much should Yeatman reduce the NPV of this project if it discovered that this project would reduce one of its divisions net after-tax cash flows by $300 for each year of the four-year project?

$559

$1,024

$698

$931

Yeatman spent $2,250 on a marketing study to estimate the number of units that it can sell each year. What should Yeatman do to take this information into account?

Increase the amount of the initial investment by $2,250.

The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost.

Increase the NPV of the project $2,250.