Question

A proposed cost-saving device has an installed cost of $810,000. The device will be used in a five-year project but is classified as three-year MACRS property for tax purposes. The required initial net working capital investment is $85,000, the marginal tax rate is 25 percent, and the project discount rate is 10 percent. The device has an estimated Year 5 salvage value of $130,000. What level of pretax cost savings do we require for this project to be profitable?

Answer 1

1]	Initial cash flow = -810000-85000 =	$         -8,95,000
2]	PV of depreciation tax shields:
	Year	Depreciation %	Depreciation	Tax shield at 25%	PVIF at10%	PV at 10%
	1	33.33	$           2,69,973	$                 67,493	0.90909	$         61,358
	2	44.45	$           3,60,045	$                 90,011	0.82645	$         74,389
	3	14.81	$           1,19,961	$                 29,990	0.75131	$         22,532
	4	7.41	$              60,021	$                 15,005	0.68301	$         10,249
					0.62092
	Total	100	$           8,10,000	$            2,02,500	3.79079	$      1,68,528
	PV of depreciation tax shields =	$           1,68,528
3]	PV of terminal non operating cash flows:
	After tax salvage value = 130000*(1-25%) =	$              97,500
	Recovery of NWC	$              85,000
	Terminal non operating cash flow	$           1,82,500
	PV of terminal non operating cash flow = 182500*0.62092 =	$           1,13,318
4]	Sum PV of known cash flows = -895000+168528+113318=	$        -6,13,154
	For the project to be profitable the NPV should be
	at the least .
	For 0 NPV, the PV of the after tax cost savings should be at least 613154/3.79079 =	$           1,61,748
	Hence, pretax cost savings required = 161748/(1-25%) =	$           2,15,665
		[Answer]