Simtel, a leading semi-conductor manufacturer, is contemplating investing in a new "Gigantium" chip manufacturing facility based on the encouraging market research report (which cost $10 million). It has already spent $250 million on a test run of manufacturing this chip. The plant and equipment used for chip manufacturing becomes worthless once the chip is obsolete. For the Gigantium project, Simtel would need to make an immediate investment of $1.6 billion in plant and equipment. Simtel plans to use the cash it has on hand to make this investment. Simtel is currently at its target capital structure. It expects the life of the Gigantium chip to be 8 years.

The company plans to sell 10 million chips at a price of $80 per chip. The Cost of Goods Sold (COGS) (excluding depreciation) is estimated at 30% of sales while Selling & General Administration (SG&A) expenses (excluding depreciation) are estimated at 10% of the sales.

For calculating depreciation expense, the company has two options

1. The straight line method (i.e. $1.6 billion divided by 8 years of useful life) thus translating into an annual depreciation expense of 200 million each year
2. The Double Declining Balance (DDB) method for the first 3 years, followed by the straight line method for the last 5 years.
3. a. Under the DDB method, first depreciation as a percentage of total assets is estimated - since the life of the project is 8 years, this translates into 1/8 = 12.5%.

b. Next, this fraction is doubled (2*12.5%=25%). The resulting fraction is multiplied by the remaining book value of the asset (also known as the depreciable base).

i. For Gigantium, in the first year DDB depreciation would be 25%*1,600 million =$400 million.

ii. In the second year, the depreciable base is only $1,200 million ($1,600 - 400 = 1,200), thus the DDB depreciation is 25%*1,200= $300 million.

1. Assume that in each of the 8 years, Simtel maintains the same level of production (10 million chips) and expects the sales price to remain constant ($80 per chip). Also assume that the company faces no taxes (Tax Rate =0%) and uses a 14% discount rate Estimate the NPV of the project under two different depreciation schedules.

QUESTIONS:

a. What is the NPV if company follows straight-line depreciation (option 1)?

b. What is the NPV if company follows DDB for the first three years and straight line there after (option 2)?

Answer rating: 100% (QA)

SOLUTION Certainly Lets calculate the NPV for each option a NPV with straightline depreciation option 1 Year 0 Cash flow 16 billion 1 0140 16 billion Years 18 Sales 10 million chips 80 800 million COG... View the full answer