TexMex Products is considering a new salsa whose data are shown below. The equipment has a constant capital cost allowance over its 3-year life with a zero salvage value. No new working capital would be required. Revenues and cash operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce the company's pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3. Actual CCA varies. The proposed CCA is for computational convenience.) WACC10.0%
Pre-tax cash flow reduction in other products (cannibalization)$5,000
Investment cost$65,000
Annual capital cost of allowance$21,665
Annual sales revenues$75,000
Annual cash operating costs$25,000
Tax rate35.0%
A) $25,269
B) $26,599
C) $27,929
D) $29,325

Question

Quizplus · Accepted Answer

To calculate the NPV, we need to calculate the annual cash flows first:

Year 1: 
Revenues: $75,000 
Cash operating costs: $25,000 
Capital cost allowance: $21,665 
Profit before tax: $28,335 
Tax: $9,336.25 (35% of profit before tax) 
Profit after tax: $18,998.75 
Cash flow: $18,998.75 - cannibalization of $5,000 = $13,998.75

Year 2: 
Revenues: $75,000 
Cash operating costs: $25,000 
Capital cost allowance: $21,665 
Profit before tax: $28,335 
Tax: $9,336.25 
Profit after tax: $18,998.75 
Cash flow: $18,998.75 - cannibalization of $5,000 = $13,998.75

Year 3: 
Revenues: $75,000 
Cash operating costs: $25,000 
Capital cost allowance: $21,665 
Profit before tax: $28,335 
Tax: $9,336.25 
Profit after tax: $18,998.75 
Cash flow: $18,998.75 - cannibalization of $5,000 = $13,998.75

Now, we can calculate the NPV using the formula: 
NPV = (CF1 / (1 + WACC)^1) + (CF2 / (1 + WACC)^2) + (CF3 / (1 + WACC)^3) - Initial investment

NPV = ($13,998.75 / (1 + 0.10)^1) + ($13,998.75 / (1 + 0.10)^2) + ($13,998.75 / (1 + 0.10)^3) - $65,000 
NPV = $26,599

Therefore, the best choice is B, with an NPV of $26,599.

TexMex Products Is Considering a New Salsa Whose Data Are