Question

A taxable entity is planning to purchase an equipment that will save 2,000 per year for 5 years. Cost of the equipment is 7,000. For tax purposes, this machine can be depreciated in 3 years using straight line method. Assume tax rate to be 40% and discount rate to be 9%.

a) What is the savings in each of the five years?

b) What is the NPV of the project?

c) Should the entity purchase the equipment?

Please put in Excel and explain

Answer 1

a: Depreciation in each year = Cost of equipment/ Useful life

= 7000/3

= 2333.33

Tax shield on depreciation = Depreciation*40%

= 2333.33 *40%

= 933.33

Annual savings after tax = 5000*(1-0.4) = 3000

Savings in years 1 to 3 = 3000+ 933.33 = 3933.33

Years 4 and 6 = 3000

b: NPV is as follows

Year	Cost of equipment	Tax shield on depreciation	Annual savings	Cash flows
0	-7000			-7000
1		933.332	3000	3933.33
2		933.332	3000	3933.33
3		933.332	3000	3933.33
4			3000	3000
5			3000	3000
			NPV	7031.49

Since NPV is positive the equipment should be purchased,

WORKINGS