Question

A firm is considering the following two competing proposals for the purchase of new equipment.

Assume straight-line depreciation and a tax rate of 20 percent.

(a) Calculate the net present value of each alternative at a discount rate of 10 percent.

(b) If 10 percent is the required rate of return, which alternative should be selected? Why?

Please show all steps. Don't round off until you get to the end.

	A	B
Net Cash Outlay	9000	7500
Salvage Value	0	0
Estimated Life	5 years	5 years
Net Cash Savings before Depreciation and Taxes
Year 1-3	3000	2000
Year 4-5	2500	2000

Answer 1

a.
NPV of Proposal A = 940.998 = 941
NPV of Proposal B = -297.505 = 298
b.
As proposal A has the positive NPV hence alternative A should be selected
Proposal A
Cost of equipment = 9000
Salvage Value = 0
Estimated Life = 5 years
Depreciation = 9000/5year = 1800
Sl. No.	Year	0	1	2	3	4	5
a	Net Cash Outlay	-9000
b	Net Cash Savings before Depreciation and Taxes		3000	3000	3000	2500	2500
c	Less: Depreciation		1800	1800	1800	1800	1800
d	Net Savings before Taxes (b - c)		1200	1200	1200	700	700
e	Less: Tax @ 20% (20% of d)		240	240	240	140	140
f	Net Savings after Taxes (d - e)		960	960	960	560	560
g	Net Cash Savings (f + c)		2760	2760	2760	2360	2360
h	Present Value of 1 at 10% {1 / (1 + r)^t}		0.909091	0.826446	0.751315	0.683013	0.620921
i	Present value of net cash savings (g * h)		2509.091	2280.992	2073.629	1611.912	1465.374
Now,
NPV = Present value of net cash savings - initial investment
NPV = (2509.091+2280.992+2073.629+1611.912+1465.374) - 9000
NPV = 9940.998 - 9000
NPV = 940.998
Proposal B
Cost of equipment = 7500
Salvage Value = 0
Estimated Life = 5 years
Depreciation = 7500/5year = 1500
Sl. No.	Year	0	1	2	3	4	5
a	Net Cash Outlay	-7500
b	Net Cash Savings before Depreciation and Taxes		2000	2000	2000	2000	2000
c	Less: Depreciation		1500	1500	1500	1500	1500
d	Net Savings before Taxes (b - c)		500	500	500	500	500
e	Less: Tax @ 20% (20% of d)		100	100	100	100	100
f	Net Savings after Taxes (d - e)		400	400	400	400	400
g	Net Cash Savings (f + c)		1900	1900	1900	1900	1900
h	Present Value of 1 at 10% {1 / (1 + r)^t}	1	0.909091	0.826446	0.751315	0.683013	0.620921
i	Present value of net cash savings (g * h)		1727.273	1570.248	1427.498	1297.726	1179.751
Now,
NPV = Present value of net cash savings - initial investment
NPV = (1727.273+1570.248+1427.498+1297.726+1179.751) - 7500
NPV = 7202.495 - 7500
NPV = -297.505