Kaplan Study Text Section C - Sludgewater Q22

Hello Sir, Sludgewater, a furniture manufacturer, has been reported to the antipollution authorities on several occasions in recent years, and fined substantial amounts for making excessive toxic discharges into the air. Both the environmental lobby and Sludgewater’s shareholders have demanded that it clean up its operations. If no clean up takes place, Sludgewater estimates that the total fines it would incur over the next three years can be summarised by the following probability distribution (all figures are expressed in present values). Level of fine Probability $1.0m 0.3 $1.8m 0.5 $2.6m 0.2 A firm of environmental consultants has advised that spray painting equipment can be installed at a cost of $4m to virtually eliminate discharges. Unlike fines, expenditure on pollution control equipment is tax-allowable via 25% tax-allowable depreciation (reducing balance, based on gross expenditure). The rate of corporation tax is 30%, paid with a one-year delay. The equipment will have no scrap or resale value after its expected three year working life. The equipment can be in place ready for Sludgewater’s next financial year. A European Union grant of 25% of gross expenditure is available, but with payment delayed by a year. The consultant’s charge is $200,000 and the new equipment will raise annual production costs by 2% of sales revenue. Current sales are $15 million per year, and are expected to grow by 5% per year compound. No change in working capital is envisaged. Sludgewater applies a discount rate of 10% after tax on investment projects of this nature. All cash inflows and outflows occur at year ends. Required: (a) Assess the proposed investment by calculating the expected net present value. My doubt is that why have they not included incremental Sales revenue and the tax in the solution when calculating expected NPV and why is the tax allowance starting from year 0, we usually do it from year 1 and why is there tax allowance on 1.687 whereas we usually subtract sales proceeds from 2.25 which are 0 here so the entire allowance should be on 2.25. I am confused. Please help me with the same. Thank you.