Dog Up Franks is looking at a new sausage system with an installed cost of $530,000. This cost...

Question:

Dog Up Franks is looking at a new sausage system with an installed cost of $530,000. This cost will be depreciated straight-line to zero over the project's five-year life, at the end of which the sausage system can be scrapped for $80,000. The sausage system will save the firm $210,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $39,000.

If the tax rate is 35% and the discount rate is 9%, what is the NPV of this project? (Do not round intermediate calculations and round final answer to 2 decimal places.)

Net Present Value

NPV is the difference between initial outlay and present value of cash flow. Discount factors are used to find out the present value of cash flow. If NPV is positive than project should be accepted.

Answer and Explanation:

Step 1

Find after tax salvage of machine

gain = sale value-book value

=$80,000-$0 (depreciated to zero so book value will be zero)

=$80,000

Tax = $80,000*35%

=$28,000

After tax salvage = $80,000-$28,000

=$52,000

Step 2

Find depreciation tax shield

Depreciation is a non cash expense so it does not result in an actual cash outflow however it is an allowable expense so it saves tax.

Depreciation = $530,000/5

=$106,000

Tax = $106,000*35%

=$37,100

Step 3

After tax cost savings

=Cost saved(1-t)

=$210,000 (1-0.35)

=$210,000*0.65

=$136,500

Step 4

Initial outlay

=Cost of machine+working capital

=$530,000+$39,000

=$569,000

Step 5

cash flow for year 1-4 = depreciation tax shield + after tax cost savings

=$37,100+$136,500

=$173,600

cash flow for year 5 =depreciation tax shield + after tax cost savings+working capital freed up+after tax salvage

=$173,600+$39,000+$28,000

=$240,600

Step 6

Present value of cash flows

{eq}PV = \displaystyle\frac{FV}{(1+R)^1}+\displaystyle\frac{FV}{(1+R)^1}....\displaystyle\frac{FV}{(1+R)^N} {/eq}

{eq}PV = \displaystyle\frac{173,600}{(1+0.09)^1}+\displaystyle\frac{173,600}{(1+0.09)^2}+\displaystyle\frac{173,600}{(1+0.09)^3}+\displaystyle\frac{173,600}{(1+0.09)^4}+\displaystyle\frac{240,600}{(1+0.09)^5} {/eq}

=562415.37+156373.49

=$718,788.86

Step 7

Net present value = -initial outlay+present value of cash outflow

=-$530,000+$718,788.86

=$188,788.86


Learn more about this topic:

Loading...
Cost of Capital: Flotation Cost, NPV & Internal Equity

from Corporate Finance: Help & Review

Chapter 3 / Lesson 18
1.8K

Related to this Question

Explore our homework questions and answers library