Question

6. Bendog's Franks is looking at a new system with an installed cost of $425,000. This equipment is depreciated at a rate of 20% per year over the project's life of 6 years, at the end of which the system can be sold for $100,000. The sausage system will save the firm $104,500 per year in pretax operating costs, and the system requires an initial investment in net working capital of $23,500. If the tax rate is 37% and the discount rate is 11%, should Bendogs Franks buy the system based on the NPV rule? Will Bendog's Franks change its mind if the return is 8% and everything else stays the same?

Answer 1

Net present value Present value of cash inflow- Present value of cash outflow Initial investment-$425000 (cost of asset) 23500 (working capital) Initial investment - $448,500 Annual cash flows: Annual saving = $ 104500 before tax So After tax saving would be-104500 (1-tax rate) 104500*0'63-$ 65835 Present value of annual savings-65835 * PVAF(1%,t) Present value of annual savings-65835 * PVAF(11%,6) Present value of annual savings 65835 4'23054 Present value of annual savings $278,51746 Calculation of tax shield from depreciation f c e g Tax savings PVF@11% PV tax saving d a- C h f *g year op.value rate Depreciation Closing Valutax rate 4250002096 85,000'00 340,000'00 3400002096 68,000'00 272,000'00 2720002096 54,400'00 217,600'00 2176002096 43,520'00 174,080'00 174080 20% 34,8|6'00 139,264100 139264 20% 37% 31,450'00 0'900901 28,333,33 37% 25,160100 0'8|1622 20,42042 37% 20,128100 0'731191 14,7|7'42 37% 16,10240 0'65873| 10,607'15 37% 12,88!'92 0'593451 7,64479 37% 10,305154 0'534641 5,509!76 87,232'88 6 27,852'80 111,41|'20