Question

4) A firm is considering the following investment project. Assume a 5-year property for MACRS Before-Tax Cash Flow Year (thousands) 0 - 100,000 +35,000 +35,000 +35,000 +35,000 5 +35,000 The income tax rate is 21%. If the firm requires a 10% after-tax rate of return, should the project be undertaken? MACRS depreciation will be used.

Answer 1

Year	Before Tax Cash Flow	Depreciation	EBIT	Tax at 21% on EBIT	NOPAT	OCF	Tax shield on loss on scrapping the project	FCF	PVIF at 10%	PV at 10%
0	$   -1,00,000							$   -1,00,000	1	$ -1,00,000
1	$         35,000	$          20,000	$         15,000	$          3,150	$         11,850	$       31,850		$        31,850	0.90909	$      28,955
2	$         35,000	$          32,000	$           3,000	$              630	$           2,370	$       34,370		$        34,370	0.82645	$      28,405
3	$         35,000	$          19,200	$         15,800	$          3,318	$         12,482	$       31,682		$        31,682	0.75131	$      23,803
4	$         35,000	$          11,520	$         23,480	$          4,931	$         18,549	$       30,069		$        30,069	0.68301	$      20,538
5	$         35,000	$          11,520	$         23,480	$          4,931	$         18,549	$       30,069	$          1,210	$        31,279	0.62092	$      19,422
		$          94,240							NPV =	$      21,122
As the NPV is positive, the project should be undertaken.
Note:
The book value of the property at EOY 5 = 100000-94240 =				$          5,760
As the project would be scrapped, the loss would be				$          5,760
Tax shield on loss = 5760*21% =				$          1,210
This tax shield on loss is a positive cash flow at EOY 5.