Question

Your firm is considering the purchase of a new piece of equipment for $20,000.

The equipment will be straight line depreciated over four years. The salvage value (final book value) is 10 percent of the purchase price.The equipment will increase the earnings before interest, tax and depreciation by $8000 for each of the four years the equipment is used. The tax rate is 21 percent and the required rate of return is 10 percent.

Should the equipment be purchased?

No. NPV = 5227.72

Yes. NPV = 5944.89

No. NPV = 3448.62

Answer 1

Calculation of Net cash inflows:

EBDT	8000
Less: Depreciation	-4500
EBT	3500
Less: Tax @ 21%	-735
EAT	2765
Add: Depreciation	4500
Net cash inflows	7265

Calculation of Net Present Value(NPV):

Year	Cash Flow	PV factor @ 10%	Present Value
0	-20000	1	-20000
1	7265	0.909090909	6604.545455
2	7265	0.826446281	6004.132231
3	7265	0.751314801	5458.302029
4	7265	0.683013455	4962.092753
4	2000	0.683013455	1366.026911
NPV			4395.099378

Yes, Equipment can be purchased as it has positive NPV of $4,395

Note:

Depreciation = (Cost - Salvage value)/useful life = ($20,000 - 2,000)/4 = $4,500

EBDT = Earnings before depreciation and tax

EBT = Earnings before tax

EAT = Earnings after tax