Requesting Help from Smart People - (PE / IB) Interview Question
Hey guys,
Trying to get insight into solving the interview question below. How does one go about solving it? Thanks for the help!
After a having expensed in past periods an estimated $5,000,000 in research and development for a new product, the Widget Company is faced with the decision of whether to invest a total of $1,500,000 in a large-scale initial promotional and advertising campaign to bring the product to market. The campaign will be conducted over a six-month period and all costs will be expensed in the current year.
If ABC decides to go ahead with the campaign, it estimates that profits generated by sales of the new product will be higher by $300,000 in the first year, $500,000 in the second, $600,000 in the third, $500,000 in the fourth and $400,000 in the fifth year (all before taxes and not including the initial promotional cost).
Assume that income taxes on incremental profits are paid at the rate of 30%. Explain whether the company should undertake this investment.
Minus present value discounting, I think it would be total additional sales profit of $2.3 million - $1.5 million in promotion costs, so the company should undertake the investment.
You didn’t account for taxes on the profits. That said, I think the whole point of the question is PV discounting, which gets you an IRR of 2% when accounting for taxes on the profits. So if your cost of capital is less than 2% (unlikely), you should undertake the investment. If it’s higher (likely), then you shouldn’t undertake the investment.
Should you account for tax savings from the $1.5m promotion expense?
You are probably right, and then IRR becomes 15%, which is more likely to be above their cost of funding.
I don’t get it. Why would there be any tax savings?
Spending more on advertising would decrease taxable income, no?
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