Question

Assume that you just graduated from Mason and are employed at an investment bank making $120,000 (after-tax) per year, and you expect to make the same amount for each of the next 5 years. A classmate from BMGT643, who knows what a hard party person you were, gives you a call and tries to convince you to join forces with him on a project. The project is to produce a new type of vodka, “Hangover’s over”, that won’t make one feel hangover the next morning no matter how many bottles one drinks. If you decide to join, you will have to quit your current job, and work full-time on the project. The project requires an initial investment of $400,000 in production equipment, which can be depreciated straight-line over 5 years to a salvage value of $80,000. You own a house that you’re currently renting out for $24,000 a year and you’re planning to use the house as your office if you join the project. You expect to sell 20,000 bottles of the “Hangover’s over!” at $40 per unit each year for the next 5 years. The production cost is $15 per unit, and fixed costs associated with the project are estimated to amount $150,000 per year. Assume that your tax rate is 40% and your discount rate for projects with similar risk is 12%. Should you accept the project?

Answer 1

Tax rate		40%
	Year-0	Year-1	Year-2	Year-3	Year-4	Year-5
Units		20,000	20,000	20,000	20,000	20,000
Sale Price		40	40	40	40	40
variable cost		15	15	15	15	15
Sale		800,000	800,000	800,000	800,000	800,000
Less: Operating Cost		300,000	300,000	300,000	300,000	300,000
Contribution		500,000	500,000	500,000	500,000	500,000
Less: Fixed Cost		150,000	150,000	150,000	150,000	150,000
Less: Implied house rent		24,000	24,000	24,000	24,000	24,000
Less: Implied Salary gross of tax (120000/(1-40%)		200,000	200,000	200,000	200,000	200,000
Less: Depreciation as per table given below		64,000	64,000	64,000	64,000	64,000
Profit before tax		62,000	62,000	62,000	62,000	62,000
Tax		24,800	24,800	24,800	24,800	24,800
Profit After Tax		37,200	37,200	37,200	37,200	37,200
Add Depreciation		64,000	64,000	64,000	64,000	64,000
Cash Profit After tax		101,200	101,200	101,200	101,200	101,200
Cost of macine			400,000
Depreciation			320,000
WDV			80,000
Sale price			80,000
Profit/(Loss)			-
Tax			-
Sale price after tax			80,000
Depreciation		Year-1	Year-2	Year-3	Year-4	Year-5	Total
Cost		320,000	320,000	320,000	320,000	320,000
Dep Rate		20.00%	20.00%	20.00%	20.00%	20.00%
Deprecaition		64,000	64,000	64,000	64,000	64,000	320,000
Calculation of NPV
						12.00%
Year		Captial		Operating cash	Annual Cash flow	PV factor	Present values
0		(400,000)			(400,000)	1.000	(400,000)
1				101,200	101,200	0.893	90,357
2				101,200	101,200	0.797	80,676
3				101,200	101,200	0.712	72,032
4				101,200	101,200	0.636	64,314
5		80,000		101,200	181,200	0.567	102,818
					Net Present Value		10,198
Since NPV is positive, the project should be accepted