Question

Yosef Drug Store is considering the purchase of an automated pill machine that fills prescriptions. The machine costs $600,000 and will last five years before becoming obsolete. The system will be depreciated using a three-year MACRS schedule and will be sold for $75,000 at the end of five years. The machine will allow Hilltop to reduce staffing and save $275,000 annually. The machine requires higher levels of inventory. Therefore, the project will require an additional $15,000 in working capital at the beginning of the project and an additional $4,000 in each subsequent year (years 1-4). All NWC investments will be recovered in the last year. Yosef has a 20 percent tax rate and expects an 8 percent return from its projects, What is the project NPV?

Answer 1

Solution: Annual Saving = $275,000

Tax rate = 20%

After-tax annual savings = Annual Savings *(1-tax rate%) = 275000*(1-20%) = $220,000

	t=0	t=1	t=2	t=3	t=4	t=5
Savings		$ 2,75,000	$ 2,75,000	$ 2,75,000	$ 2,75,000	$ 2,75,000
Tax Expense		$     55,000	$     55,000	$     55,000	$     55,000	$     55,000
After-tax Savings		$ 2,20,000	$ 2,20,000	$ 2,20,000	$ 2,20,000	$ 2,20,000

Depreciation Expense = Depreciation Rate*Initial Cost

Initial Cost = $600,000

3 year MACRS schedule	Rates	Depreciation Amount
Year 1	33.33%	$        1,99,980
Year 2	44.45%	$        2,66,700
Year 3	14.81%	$            88,860
Year 4	7.41%	$            44,460

Thus, Asset schedule is calculated as:

	t=0	t=1	t=2	t=3	t=4	t=5
Asset Value	$         6,00,000	$ 4,00,020	$ 1,33,320	$     44,460	$               -	$               -

Since, the asset is sold for $75,000 at the end of year 5, hence, there will be profit/gain on selling the machinery.

Gain on Sale of Asset = Selling Price - Book Value of Asset (as per asset schedule)

= 75000 - 0 = $75,000

Thus, this gain would lead to tax expense at a tax rate of 20%

Tax Expense in Year 5 = 75000 * 20% = $15,000

Cash flows for Net Working Capital:

	t=0	t=1	t=2	t=3	t=4	t=5
Net Working Capital	-15000	-4000	-4000	-4000	-4000	31000

Since, the whole Working Capital invested is reversed in year 5, thus, the cash flow in year 5 = 31000

The net cash flows are as follows:

	t=0	t=1	t=2	t=3	t=4	t=5
Costing	$        -6,00,000
After-tax Savings		$ 2,20,000	$ 2,20,000	$ 2,20,000	$ 2,20,000	$ 2,20,000
Depreciation		$ 1,99,980	$ 2,66,700	$     88,860	$     44,460	0
Net Working Capital	$           -15,000	$      -4,000	$      -4,000	$      -4,000	$      -4,000	$     31,000
Salvage Value						$     75,000
Tax on Sale of Machinery					$    -15,000
Net Cash Flows	$        -6,15,000	$ 4,15,980	$ 4,82,700	$ 3,04,860	$ 2,60,460	$ 3,11,000

Using NPV function in excel, = NPV(expected return on project, Cash Flows) + Initial Investent

NPV of the Project = $829,119.06