Assume that the before-tax required rate of return for Deer Valley is 14%. Compute the before-tax NPV of the new lift and advise the managers of Deer Valley about whether adding the lift will be a profitable investment. Show calculations
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Individual Project Unit Five ACG_420 Managerial Accounting And Organizational Controls July 8, 2006 Introduction Deer Valley Lodge, a ski resort in the Wasatch Mountains of Utah, has plans to eventually add five new chairlifts. Suppose that one lift costs $2 million, and preparing the slope and installing the lift costs another $1.3 million. The lift will allow 300 additional skiers on the slopes, but there are only 40 days a year when the extra capacity will be needed. (Assume that Deer park will sell all 300 lift tickets on those 40 days.) Running the new lift will cost $500 a day for the entire 200 days the lodge is open. Assume that the lift tickets at Deer Valley cost $55 a day and the added cash expenses for each skier-day are $5. The new lift has an economic life of 20 years. 1. Assume that the before-tax required rate of return for Deer Valley is 14%.
Part 2: 1. What is the after tax value of net cash flows as determined in question #1? 500,000 - (500,000 * 40%) = $300,000 2. What is the present value of this annuity? (Use table 2) 20 years, 8% $300,000 * 9.8181 = $2,945,430 3. What is tax savings from MACRS depreciation (Use directions on top of page 490) and what is the present value of this tax savings (Use Exhibit 11-7 for the PV factor)? Initial investment * tax rate * PV factor (8%, 10 years) $3.3 million * 40% *.7059 = $931,788 4. Add the two computations together and compare to the initial investment. Is it still profitable on an after tax basis? PV of after tax cash flows vs. initial investment $2,945,430 + $931,788 = $3,877,218 vs. $3,300,000 $3,877,218 - $3,300,000 = $577,218 My recommendation to the managers of Deer Valley is to add the chairlift. The after tax profit will be $577,218 making it a profitable investment.
NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. NPV compares the value of a dollar today versus the value of that same dollar in the future, after taking inflation and return into account. Basically, once the calculations are completed and the NPV of a prospective project is positive, then it should be accepted. However, if it is negative, then the project probably should be rejected because cash flows are negative. The minimum desired rate of return can have a large effect on NPV -the higher the minimum desired rate of return, the lower the present value of each future cash inflow and the lower the NPV of the project. Investments that are desirable at one rate of interest may be undesirable at a higher rate of interest. Since we are concerned with cash flows, and not revenues and expenses, depreciation is an expense that does not require a current cash outlay. Depreciation affects capital budgeting decisions by creating a tax savings in the amount of the tax rate multiplied by the depreciation claimed.
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