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Temporary Housing Services (THS)is considering a project that involves setting up a temporary housing facility in an area recently damaged by a cyclone. THS will lease space in this facility to various agencies and groups providing relief services to the area. THS estimates that this project will initially cost $6 million to set up and will generate $22 million in revenues during its first and only year of operation (paid in one year). Operating expenses are expected to total $13 million during this year and depreciation expense will be another $4 million. THS will require no working capital for this investment. THS's marginal tax rate is 30%.
-Assume that THS's cost of capital for this project is 15%. The net present value (NPV)of this temporary housing project is closest to:
A)-$435 000
B)$520 000
C)$1 960 000
D)-$650 000

Question

Quizplus · Accepted Answer

The NPV calculation involves finding the present value of the project's cash flows. The project's cash flow can be calculated as follows: Revenue ($22 million) - Operating Expenses ($13 million) - Depreciation ($4 million) = Earnings Before Tax ($5 million). Taxes (30% of $5 million) = $1.5 million. Thus, Net Income = $5 million - $1.5 million = $3.5 million. Adding back the non-cash depreciation charge gives us a cash flow of $3.5 million + $4 million = $7.5 million. The initial investment is $6 million, so the net cash flow in year one is $7.5 million - $6 million = $1.5 million. To find the NPV, we discount this back at the project's cost of capital (15%): NPV = -$6 million + ($7.5 million / (1 + 0.15)) = -$6 million + $6.52 million = $520,000.

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