Question

Dog Up! Franks is looking at a new sausage system with an installed cost of $540,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $80,000. The sausage system will save the firm $170,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $29,000. If the tax rate is 34 percent and the discount rate is 10 percent, what is the NPV of this project?

Answer 1

Initial Investment = $540,000
Useful Life = 5 years

Annual Depreciation = Initial Investment / Useful Life
Annual Depreciation = $540,000 / 5
Annual Depreciation = $108,000

Initial Investment in NWC = $29,000

Salvage Value = $80,000

After-tax Salvage Value = $80,000 * (1 - 0.34)
After-tax Salvage Value = $52,800

Annual Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Annual Operating Cash Flow = $170,000 * (1 - 0.34) + 0.34 * $108,000
Annual Operating Cash Flow = $170,000 * 0.66 + 0.34 * $108,000
Annual Operating Cash Flow = $148,920

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$540,000 - $29,000
Net Cash Flows = -$569,000

Year 1 to Year 4:

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $148,920

Year 5:

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $148,920 + $29,000 + $52,800
Net Cash Flows = $230,720

Required return = 10%

NPV = -$569,000 + $148,920/1.10 + $148,920/1.10^2 + $148,920/1.10^3 + $148,920/1.10^4 + $230,720/1.10^5
NPV = $46,315.33

So, the net present value of this project is $46,315.33