Esfandiari enterprises is considering a new three year expansion project that requires an initial fixed asset investment of 2.27 million. The fixed assets will be depreciated straight line to zero over it’s , three year tax life, after which time it will be worthless. the project is estimated to generate 1800000 in annual sales, with costs of 710,000. the tax rate is 23 percent and the required return on the project is 11 percent. what is the projects NPV?
The Correct Answer and Explanation is :
The Net Present Value (NPV) of the project is approximately $206,298.
Explanation:
- Initial Investment: The project requires an upfront investment of $2.27 million, which represents a cash outflow at time 0.
- Depreciation: Since the fixed asset is depreciated straight-line over three years to zero, the annual depreciation expense is:
[
\text{Depreciation Expense} = \frac{\text{Initial Investment}}{\text{Project Life}} = \frac{2,270,000}{3} = 756,667
] - Operating Income: The annual operating income before tax is calculated by subtracting costs and depreciation from annual sales:
[
\text{Operating Income} = \text{Sales} – \text{Costs} – \text{Depreciation} = 1,800,000 – 710,000 – 756,667 = 333,333
] - Net Income After Tax: The tax effect is considered by applying the tax rate to the operating income:
[
\text{Net Income} = \text{Operating Income} \times (1 – \text{Tax Rate}) = 333,333 \times (1 – 0.23) = 256,667
] - Cash Flow: Depreciation is a non-cash expense, so it is added back to net income to calculate the annual cash flow:
[
\text{Annual Cash Flow} = \text{Net Income} + \text{Depreciation} = 256,667 + 756,667 = 1,013,333
] - NPV Calculation: The NPV is the sum of the discounted cash flows over the project’s life, minus the initial investment:
[
\text{NPV} = -\text{Initial Investment} + \sum_{t=1}^{3} \frac{\text{Annual Cash Flow}}{(1 + \text{Required Return})^t}
]
Substituting values, the NPV is approximately $206,298.
Conclusion:
Since the NPV is positive, the project is expected to generate value above the required return, making it a financially viable investment.