Straight-line basis over three years

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Garcia Paper is deciding whether to build a new plant. The proposed project would have an up-front cost (at t = 0) of $30 million. The project's cost can be depreciated on a straight-line basis over three years. Consequently, the depreciation expense will be $10 million in each of the first three years, t = 1, 2, and 3. Even though the project is depreciated over three years, the project has an economic life of five years.

The project is expected to increase the company's sales by $20 million. Sales will remain at this higher level for each year of the project (t = 1, 2, 3, 4, and 5). The operating costs, not including depreciation, equal 60 percent of the increase in annual sales. The project's interest expense is $5 million per year and the company's tax rate is 40 percent. The company is very profitable, so any accounting losses on this project can be used to reduce the company's overall tax burden. The project does not require any additions to net operating working capital. The company estimates that the project's after-tax salvage value at t = 5 will be $1.2 million. The project is of average risk, and, therefore, the CFO has decided to discount the operating cash flows at the company's overall WACC of 10 percent. However, the salvage value is more uncertain, so the CFO has decided to discount it at 12 percent. What is the net present value (NPV) of the proposed project?

Reference no: EM13939615

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