(NPV/single project): You are working on a project that will improve labor productivity in your plant. Total BT labor and labor-related savings are expected to be $925K per year. These savings will begin one year after the making the capital investment. The project requires a capital investment of

Question

(NPV/single project): You are working on a project that will improve labor productivity in your plant. Total BT labor and labor-related savings are expected to be $925K per year. These savings will begin one year after the making the capital investment. The project requires a capital investment of $1560K. You have estimated the added costs due to the capital investment will be $102K per year plus depreciation.* You expect your project to have a life of 10 years. Your company’s hurdle rate is 20% for cost reduction projects, its tax rate is 35%, and it uses the straight-line method for depreciation. What is the NPV for your project?

Accepted Answer

The labor savings minus the added costs and depreciation occur every year from Year 1 (one year after making the capital investment) to Year 10 (the end of the project’s life). Notice that this meets the definition of an annuity.
Find the annual depreciation writeoff using Equation 2.5:

[latex] ext{Annual deprecation writeoff}= \frac{ ext{Capital investment}}{ ext{Equipment life}}[/latex]

Depreciation = $1560K/10 = $156K per year
The annual BT earnings increase is:
BT cash flow = Labor savings – Added costs – Depreciation

= $925K – 102K – 156K = $667K per year

Drawing the cash flow diagram:

Find the AT cash flow using Equation 2.6:
AT Cash Flow = (BT Earnings)(1 – Tax rate) + Depreciation write-off
= $667K/yr (1 – 0.35) + 156K/yr = $590K per year
Find the NPV:
[latex]P_{capital} = – \$1560K[/latex]
(This is not discounted because it is spent in Year 0. Also note that this is negative because it is a cash flow out.)
[latex]P_{ ext{AT cash flow}} = A(P/A, 20 \%, 10) = (\$590K)(4.192) = \$2473K[/latex]

[latex]NPV = P_{ ext{capital}} + P_{ ext{AT cash flow}} = – \$1560K + 2473K = \$913K[/latex]

Question 5.2: (NPV/single project): You are working on a project that will...

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