Question

A firm is considering investing $15 million in machinery equipment that is expected to have a useful life of five years and is expected to reduce the firm's labor costs by $5 million per year. Assume the firm pays a 30% tax rate on accounting profits and uses the straight-line depreciation method. What is the after-tax cash flow from the investment in years 1 through 5? If the hurdle rate for this investment is 15% per year, is it worthwhile? What are the IRR and NPV of the investment?

Answer 1

Time line		0	1	2	3	4	5
Cost of new machine		-15
=Initial Investment outlay		-15
								100.00%
Savings			5	5	5	5	5
-Depreciation	Cost of equipment/no. of years		-3	-3	-3	-3	-3	0	=Salvage Value
=Pretax cash flows			2	2	2	2	2
-taxes	=(Pretax cash flows)*(1-tax)		1.4	1.4	1.4	1.4	1.4
+Depreciation			3	3	3	3	3
=1. after tax operating cash flow			4.4	4.4	4.4	4.4	4.4
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							0
Total Cash flow for the period		-15	4.4	4.4	4.4	4.4	4.4
Discount factor=	(1+discount rate)^corresponding period	1	1.15	1.3225	1.520875	1.7490063	2.0113572
Discounted CF=	Cashflow/discount factor	-15	3.826087	3.3270321	2.8930714	2.5157143	2.1875776
2. NPV=	Sum of discounted CF=	-0.25

Total Cash flow for the period		-15	4.4	4.4	4.4	4.4	4.4
Discount factor=	(1+discount rate)^corresponding period	1	1.1430455	1.3065529	1.4934494	1.7070805	1.9512706
Discounted CF=	Cashflow/discount factor	-15	3.8493657	3.3676401	2.9461996	2.5775	2.2549409
NPV=	Sum of discounted CF=	0.00
IRR is discount rate at which NPV = 0 =	14.30%