BIGBIRD ENTERPRISES

You have been retained as a consultant by a business that is considering production of a new product - oversized Owl Mascots

This production would require an initial capital outlay of $24 million. This capital expenditure can be depreciated (straight line) over a 3-year life of the project with no salvage value. Assume the firm faces a 25% marginal tax rate and a cost of capital of 8%.

If the project is funded, the resulting Net Operating Profit BEFORE Depreciation & Taxes (think EBITDA) are given below.

Net Operating Profit BEFORE Depreciation & Taxes (EBITDA)

Year 1 $15,000,000

Year 2 $16,000,000

Year 3 $17,000,000

(b) You are also asked to calculate the Economic Profit (EP) for each year (Y1 to Y3). To conduct these calculations assume that the straight line depreciation suggest above is also representative of the economic depreciation. Further, using the 8% cost of capital, calculate the Present Value of the economic profits (also known as Present Value of Economic Profits). How does the present value in (a) and (b) compare?

(c) Finally, you learn that the market value of the capital depreciates faster than is reflected in the straight line method. Specifically, you learn that the capital loses 50% of its market value in the first year - but that the economic depreciation in years 2 and 3 are 25% each (of the initial value). Calculate the Economic Profits for this assumption guarding economic depreciation. Using the 8% cost of capital, calculate the Present Value of the economic profits (also known as Present Value of Economic Profits). How does the present value in (c) compare with those in (a) and (b)?