Question

2. A project requires an initial investment of $100,000 and installation cost of $20,000. The financial manager of the company expects this project will cut the direct production costs by $30,000 per year. For tax purposes the project can be depreciated straight-line over 5 years.. The company will pay insurance expense of $5,000 per year beginning with the installation of the machine. The salvage value of the machine is expected to be $15,000. If the company pays tax at a rate of 20% and the opportunity cost of capital is 20%, is the project attractive to the company?

Answer 1

Year-o $5,000 Year-1 $30,000 $5,000 $24,000 $1,000 $200 $800 Year-2 $30,000 $5,000 $24,000 $1,000 -$200 $800 Year-3 $30,000 $5,000 $24,000 $1,000 $200 $800 Annual savings in production costs Less: Annual insurance expense Less: Depreciation Expenses Before-tax net savings in costs Taxes @ 20% After-tax net savings Cost of new equipment After-tax salvage value - Machine Add back Depreciation Expenses Net Cash Flow (1) Discount factor @ 20% Present Value (1) x (2) -$5,000 $1,000 $4,000 -$120,000 Year-4 Year-5 $30,000 $30,000 (Given] $5,000 $5,000 $24,000 -$24,000 ($120000 / 5 years under straight-line method] $1,000 $1,000 $200 $200 [Before-tax net savings in costs x 20%] $800 $800 ($100,000 + $20,000] $12,000 ($15,000 x (1-20%) --> Entire value is taxable because book value is zero] $24,000 $24,000 [Non-cash expense and so added back] $24,800 $36,800 0.48225 0.40188 [1/(1+20%)°; 1/(1+20%)*; 1/(1+20%)*; 1/(1+20%)*; 1/(1+20%)*; 1/(1+20%)] $11,959.88 $14,789.09 $124,000 1.00000 $124,000 $24,000 $24,000 $24,000 $24,800 $24,800 $24,800 0.83333 0.69444 0.57870 $20,666.67 $17,222.22 $14,351.85 Net Present Value (NPV) -$45,010.29 [Sum of present value figures from year-O thru year-5] Based on NPV, this project shall be rejected because its NPV is negative. NPV rule says that a project with negative NPV shall be rejected because negative NPV implies that the project doesn't have capability to recover all cash outflows within project's economic life when time value of money is considered at cost of capital of the company.