Question

A firm is considering introducing a new product. It forecasts incremental annual gross profits (sales minus costs) from the product of $91,250, $106,750, and $114,250 for the next three years, respectively.

The project requires the purchase of a factory for $108,500, which would be straight-line depreciated over its 6-year tax life. It is estimated that the factory can be sold for $44,500 at the end of the three-year life of the project. Starting the project requires an initial net working capital investment of $21,000, with further annual increases of $5,750 during the life of the project. All net working capital is fully recoverable at cost when the project terminates. The firm pays tax at a marginal rate of 25% and the appropriate cost of capital for the project is 12.9% per annum.

Which of the following is closest to the NPV for this firm of introducing the new product?

a. $123,362

b. $52,979

c. $109,762

d. $66,992

e. $77,146

Answer 1

Answer is 109,762

	0	1	2	3
Gross Profit		91250	106750	114250
Less Depreciation		18083.33	18083.33	18083.33
Profit Before Tax		73166.67	88666.67	96166.67
Less Tax 25%		18291.67	22166.67	24041.67
Profit After Tax		54875	66500	72125
Add Depreciation		18083.33	18083.33	18083.33
Cash Flow From Operating Activities		72958.33	84583.33	90208.33
Cost of New Machine	-108500
Working Capital requirement	-21000	-5750	-5750
Recapture of Working Capital				32500
Sales of Machine				44500
Tax saving on account of loss on Sale of Machine				2437.5
Net Cash Flow	-129500	67208.33	78833.33	169645.8
PV factor 12.9%	1	0.88574	0.784535	0.694893
PV of cash flow	-129500	59529.08	61847.48	117885.8
NPV (Sum of PV of Cash flow	1,09,762.33

Tax saving from loss on sales of machine working

Sales Value 44500

Less Book value 54250 (cost less accumulated depreciation =129500-18083.33*3)

Loss 9750

Tax saving on loss 9750*25% =2437.5