Question

help with 1B

1b) A project provides a revenue of $20,000 increasing at $5,000 per year during a five-year investment period. The machine to be used on the project is purchased for $20,000 and has an expected life of 5 years. The salvage value at the end of 5 years is $2,000. Out-of-pocket expenses are $ 4000 and increases arithmetically at $1,000/yr thereafter, and depreciation deduction for income tax purposes are taken using a Sum of the Years Digit Depreciation method. What is the before tax and after tax cash flow Rate of Return if the tax rate is 40% ? If the minimum attractive rate of return is 10% will you recommend the project on an after tax cash flow basis ?

Answer 1

Calculation of depreciation

Depreciation factor in 1-5 years are=5+4+3+2+1=15

Therefore depreciation factors are 5/15,4/15,3/15,2/15,1/15

Depreciable amount =cost -salvage value=20000-2000=18000

1st year depreciation=18000×5/15=6000

2nd year=18000×4/15=4800

3rd year=18000×3/15=3600

4th year=18000×2/15=2400

5th year=18000-6000-4800-3600-2400=1200

1)Calculation of 1st year profit

Revenue. 20000

-cost 4000

-Depreciation. 6000

Profit before tax =10000

Tax 40%=4000

Profit after tax(PAT)=6000

Rate of return =6000/20000×100=30%

2)2nd year profit before tax=25000-5000-4800=15200

Tax. 40%. 6080

PAT =9120

Rate of return=9120/25000*100=36.5%

3)3rd year profit=30000-6000-3600=20400

Tax 8160

PAT 12240

Rate of return =40.8%

4)4th year profit =35000-7000-2400=25600

Tax 10240

PAT 25600-10240=15360

Rate of return =43.88%

5)5th year profit

40000-8000-1200=30800

Tax 12320

PAT 18480

Rate of return 46.2

The project is earning way more than the minimum attractive rate if 10% therefore project is very profitable