Question

A company is considering producing long telephoto zoom lens, iLongLens, attachment for the iPhone 5. The initial investment for this project will be $3 million. This amount is for depreciable equipment, which will be depreciated over 5 years using the straight-line method to zero book value. The iLongLens is expected to generate Earnings before Depreciation and Taxes of $1.5 million per year for 6 years. At the end of the sixth year the equipment will be scrapped for $300,000. The company’s tax rate is 40% and the appropriate discount rate for this project is 15%.

1. List all 7 after-tax cash flows for this project (0 is the initial investment).
2. Compute the NPV.
3. Compute the IRR and payback.

Answer 1

operating cash flow (OCF) each year = income after tax + depreciation

after-tax salvage value = salvage value - tax on profit on sale of equipment (the book value is zero, hence the entire salvage value is taxed at 40%)

NPV and IRR are calculated using NPV and IRR functions in Excel

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = 2 + (cash flow required in year for cumulative cash flows to equal zero / year 3 cash flow) = 2 + ( $720,000 / $1,140,000) = 2.63 years

NPV is $821,457

IRR is 30.00%