There is a question:
A company is investing in a $300 million project that is being depreciated on a straight straight-line basis to zero over a two two-year life with no salvage value. The project will generate operating earnings of $130 million each year for the two years. The weighted average cost of capital and required rate of return for the project is 10%. Company’s tax rate is 30%.
What is economic profit for the company in years 1 and 2?
According to the formula of economic profit in corporate finance, in the first year, $WACC=$300*10%=$30,
so the economic profit for year 1=EBIT*(1-tax rate)-$WACC=130*(1-30%)-30=61
Due to the depreciation, the value of intitial investment at the end of year 1 becomes 300-300/2=150
So for year 2, $WACC=150*10%=15,
hence economic profit=EBIT*(1-tax rate)-$WACC=130*(1-30%)-15=76
Discount these two economic profit back to the beginning time with WACC as discount rate, we get an NPV=118.26
This result sounds counter intuitive to me. We invested 300, it depreciates in two years which means we cannot get it back, instead, we only get total $WACC of $45, plus the two so called ‘economic profit’. Adding them together even without a discount rate, it is less than 300. How come we can have a profit, and how come the NPV is positive which means there is a value added to the company?
I really don’t understand where the problem comes from. Is it because of the high depreciation rate, or the low rate of required return, or something else? Can anyone explain?
