Magellen Industries is analyzing a new project. The data they have gathered to date is as follows: Initial requirement for equipment: $120,000 Depreciation: Straight-line to zero over the four-year life of the project with no salvage value.
Required rate of return: 15%
Marginal tax rate: 35%
What is the net income under the worst-case scenario?
A) -$11,575
B) -$7,524
C) $1,316
D) $4,051
E) $7,524

Question

Magellen Industries is analyzing a new project. The data they have gathered to date is as follows:  Initial requirement for equipment: $120,000 Depreciation: Straight-line to zero over the four-year life of the project with no salvage value.
Required rate of return: 15%
Marginal tax rate: 35%
What is the net income under the worst-case scenario?
A) -$11,575 
B) -$7,524 
C) $1,316 
D) $4,051 
E) $7,524

Quizplus · Accepted Answer

To calculate the net income, we need to first find the annual depreciation expense. Since the equipment has a four-year life and no salvage value, the annual depreciation expense would be $30,000 ($120,000/4 years). 
Under the worst-case scenario, we assume that the project generates the lowest possible revenue and incurs the highest possible costs. Let's say the revenue is $60,000 and the total expenses are $80,000. 
Therefore, the earnings before interest and taxes (EBIT) would be -$20,000 ($60,000 - $80,000). 
Next, we need to calculate the interest expense. Since we are not given any information on how the project is financed, we assume that it is financed entirely by debt. Let's say the interest rate on the debt is 10% and the amount borrowed is the same as the initial equipment requirement, i.e., $120,000. 
Therefore, the interest expense would be $12,000 ($120,000 x 10%). 
Now, we can calculate the earnings before taxes (EBT) by subtracting the interest expense from EBIT: 
EBT = -$20,000 - $12,000 = -$32,000. 
Since the marginal tax rate is 35%, the taxes would be: 
Taxes = 35% x (-$32,000) = -$11,200. 
Therefore, the net income would be: 
Net income = EBT - Taxes = -$32,000 - (-$11,200) = -$20,800. 
Thus, the best choice would be to not proceed with the project.

Magellen Industries Is Analyzing a New Project