Question

TCO 8) Tomcat Company is planning to acquire a $250,000 machine to improve manufacturing efficiencies, thereby reducing annual cash operating costs (before taxes) by 80,000 for each of the next five years. The company estimated the weighted average cost of capital (WACC) is 8%. The machine will be depreciated using straight-line method over a five year life with no salvage value. Fritz is subjected to a combined 40% income tax rate. Required. A. What is the estimated net present value (NPV) of the proposed investment B. What is the payback period?

Answer 1

Incremental annual operating income			$          80,000
Less: Depreciation expense (250000/5)			$          50,000
Income before tax			$          30,000
Less: Income tax (30000*40%)			$          12,000
Net income			$          18,000
Add: Depreciation expense			$          50,000
Annual net cash flow			$          68,000
Year	Cash flow	PV factor @ 8%	Present value
0	$       (250,000)	1.00000	$      (250,000)
1	$            68,000	0.92593	$          62,963
2	$            68,000	0.85734	$          58,299
3	$            68,000	0.79383	$          53,981
4	$            68,000	0.73503	$          49,982
5	$            68,000	0.68058	$          46,280
Net present value (NPV) of the proposed investment			$          21,504
Cost of Investment			$        250,000
Divided by: Annual net cash flow			$          68,000
Payback period in years			3.68