Solutions Guide: Please do not present as your own. This is only meant as a solutions guide for you to answer the problem on your own.

DeerValley Lodge, a ski resort in the WasatchMountains of Utah, has plans to eventually add five new chairlifts. Suppose that one lift costs $2 million, and preparing the slope and installing the lift costs another $1.3 million. The lift will allow 300 additional skiers on the slopes, but there are only 40 days a year when the extra capacity will be needed. (Assume that Deer park will sell all 300 lift tickets on those 40 days.) Running the new lift will cost $500 a day for the entire 200 days the lodge is open. Assume that the lift tickets at DeerValley cost $55 a day. The new lift has an economic life of 20 years.

Assume that the before-tax required rate of return for DeerValley is 14%. Compute the before-tax NPV of the new lift and advise the managers of DeerValley about whether adding the lift will be a profitable investment. Show calculations to support your answer.

Assume that the after-tax required rate of return for DeerValley is 8%, the income tax rate is 40%, and the MACRS recovery period is 10 years. Compute the after-tax NPV of the new lift and advise the managers of DeerValley about whether adding the lift will be a profitable investment. Show calculations to support your answer.

What subjective factors would affect the investment decision?

Solution

1.Investment = $2,000,000 + $1,300,000 = $3,300,000

Annual cash inflow = 300 skiers x 40 days x $55/skier-day = $660,000

Annual cash outflow

= (200 days x $500/day)= $100,000

PV of cash flows @ 14% = ($660,000 - $100,000) x 6.6231

= $3,708,953

NPV = $3,708,953 - $3,300,000 = $408,953

The new lift will create value of $408,953, so it is a profitable investment.

2.After-tax cash flows = $560,000 x .6 = $336,000

PV of after-tax cash flows @ 8% = $336,000 x 9.8181 = $3,298,897

PV of tax savings = $3,300,000 x .4 x .7059 (from Exhibit 11-7) = $936,540

NPV after-tax = $3,298,897 + $936,540 - $3,300,000 = $935,438

The investment in the lift is more profitable on an after-tax basis than on a pretax basis.

3.Subjective factors that might affect this decision include: (please reword)

Profits on sales of food, rental of equipment, and other items purchased by the additional skiers.

More satisfied customers because of less crowding on the days that the additional lift does not result in additional skiers being attracted to DeerValley.

Additional skiers may not be as many as estimated if the weather is poor.