The manager of Crain Street Cold Storage is considering the...

The manager of Crain Street Cold Storage is considering the installation of a new refrigerated storage room. She has learned that the installation would require an initial cash outlay of $$\$ 780,000$$ The installation would have an expected life of 20 years with no salvage value. The installation would increase annual labor and maintenance costs by $$\$ 75,000$$. The firm's cost of capital is estimated to be 11 percent, and its tax rate is 30 percent. The storage room is expected to generate net annual cash revenues (before tax, labor, and maintenance costs) of $\$ 172,000$. a. Using straight-line depreciation, calculate the after-tax net present value of the storage room. b. Based on your answer to part (a), is this investment financially acceptable? Explain. c. What is the minimum amount by which net annual cash revenues must increase to make this an acceptable investment?

The manager of Crain Street Cold Storage is considering the installation of a new refrigerated storage room. She has learned that the installation would require an initial cash outlay of $$\$ 780,000$$ The installation would have an expected life of 20 years with no salvage value. The installation would increase annual labor and maintenance costs by $$\$ 75,000$$. The firm's cost of capital is estimated to be 11 percent, and its tax rate is 30 percent. The storage room is expected to generate net annual cash revenues (before tax, labor, and maintenance costs) of $\$ 172,000$.
a. Using straight-line depreciation, calculate the after-tax net present value of the storage room.
b. Based on your answer to part (a), is this investment financially acceptable? Explain.
c. What is the minimum amount by which net annual cash revenues must increase to make this an acceptable investment?

Key Concepts

Depreciation (Straight-Line Method)

Depreciation is the allocation of the cost of a capital asset over its useful life. The straight-line depreciation method assigns an equal depreciation expense to each period over the asset’s lifespan. This method simplifies calculations and provides a steady expense pattern, which affects tax liabilities by creating a consistent tax shield over the capital asset's life.

Discount Rate/Cost of Capital

The discount rate, often represented by the firm's cost of capital, is used to adjust future cash flows to their present value. It reflects the opportunity cost of investing capital in a particular project rather than alternative investments. Estimating the cost of capital accurately is essential, as it directly influences the reliability of NPV and other valuation metrics.

Tax Shield

A tax shield is the reduction in taxable income resulting from allowable deductions such as depreciation, interest expenses, and certain operating costs. By lowering taxable income, a tax shield saves cash and indirectly enhances the overall cash flow of a project. In capital budgeting, considering the tax shield is crucial for accurately determining the net after-tax cash flows and, consequently, the investment’s true profitability.

Capital Budgeting

Capital budgeting is the process of evaluating and selecting long-term investments that are in line with the firm's goal of maximizing shareholder value. It involves analyzing potential projects’ cash inflows and outflows to determine whether the returns meet a sufficient target relative to the risks involved. This evaluation is critical for decisions such as installing new facilities or acquiring expensive equipment.

Net Present Value (NPV) Calculation

Net Present Value (NPV) is a method used in capital budgeting to calculate the present value of a project's expected cash flows, including both inflows and outflows, discounted at the firm's cost of capital. A positive NPV indicates that the project's returns exceed its costs, suggesting that the investment is financially attractive, while a negative NPV suggests the opposite.

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