Q：LeoVinci Gallery Ltd owns a building in North Sydney that houses their fine arts business. At present, the gallery leases out the ground floor of the building to the Young Artists Trust for a rental income of $20,000 per year. However, Sir Michael Rose, the curator of the gallery would like to expand the gallery’s bustling fine arts business by taking over the ground floor and running an additional auction house. This would necessitate terminating the Young Artists Trust’s lease and would incur an immediate penalty of $30,000 (this is not tax deductible). Sir Michael has estimated the setting up of the ground floor auction house will require $400,000 worth of fittings and equipment. This amount would be depreciated on a straight-line basis to zero over the life of the project. However, Sir Michael believes the fittings and equipment will have a market value of $50,000 at the end of the project. Sir Michael estimates that the new auction house would generate an EBDIT of $220,000 per year. The project is expected to last 4 years and the company tax rate is 30%. All cash flows are stated in nominal terms.
a) Determine the net cash flow for each year of the project.
b) What would be the payback period of the new auction house?
c) If the nominal required rate of return on the auction house project is 15% p.a. compounded annually, what is the project’s NPV? Should LeoVinci Gallery Ltd undertake this investment project?
d) Suppose that after further investigation Sir Michael believes there is a 40% chance LeoVinci will not have to pay the penalty for breaking the Young Artists Trust’s lease agreement. What impact will this have on the project’s NPV?
Please help me to correct the errors in the following answers based on the above questions
Answer：
a) Annual depreciation of the project = 400000/4 = 100000 ????
Annual taxes = (220,000 - 100,000) * 30% = 36,000 ????
Net cash flow at the beginning of the first year=
Year-end of the first year - year-end of the third year annual net cash flow = 220,000 - 36,000 = 184,000 ($)
Net cash flow at the end of the fourth year = 184,000 + 50,000 * (1 - 30%) = 219,000 ($)
b) payback period = 430,000/184,000 = 2.34 (years)
c) NPV of the project = -430000+184000*(P/A, 15%, 3)+219000*(P/F, 15%, 4)=-430000+184000*2.2832+219000*0.5718=115333 ($)
If you do not invest in the project and receive annual rental income .
Then the net present value = 30,000 * (1-30%) * (P/A, 15%, 4) = 30,000 * 0.7 * 2.8550 = 59955 ($)
Company A should invest in this project because the NPV of the investment project is greater than the NPV of the rental income that will be generated.
d) The NPV of the project will increase by $30,000 if the penalty for violating the Youth Trust Fund lease agreement is not paid.