Question

Dog Up! Franks is looking at a new sausage system with an installed cost of $741,000. This cost will be depreciated straight-line to zero over the project's 10-year life, at the end of which the sausage system can be scrapped for $114,000. The sausage system will save the firm $228,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $53,200.

Required: If the tax rate is 35 percent and the discount rate is 8 percent, what is the NPV of this project?

Answer 1

Initial Investment for the Project

Initial Investment for the Project = Cost of the asset + Working capital needed

= $741,000 + $53,200

= $794,200

Annual Operating Cash Flow (OCF)

Annual Operating Cash Flow (OCF) = Pretax Savings(1 – Tax Rate) + (Depreciation x Tax Rate)

= [$228,000 x (1 – 0.35)] + [($741,000 / 10 Years) x 0.35]

= [$228,000 x 0.65] + [$74,100 x 0.35]

= $148,200 + $25,935

= $174,135

Year 1-9 Cash flow = $174,135

Year 10 Cash flow = Annual operating cash flow + After-Tax Salvage value + Release of working capital

= $174,135 + [$114,000 x (1 – 0.35)] + $53,200

= $174,135 + [$114,000 x 0.65] + $53,200

= $174,135 + $74,100 + $53,200

= $301,435

Net Present Value of the Project

Period	Annual Cash Flow ($)	Present Value factor at 8%	Present Value of Cash Flow ($)
1	1,74,135	0.9259259	1,61,236.11
2	1,74,135	0.8573388	1,49,292.70
3	1,74,135	0.7938322	1,38,233.98
4	1,74,135	0.7350299	1,27,994.42
5	1,74,135	0.6805832	1,18,513.36
6	1,74,135	0.6301696	1,09,734.59
7	1,74,135	0.5834904	1,01,606.10
8	1,74,135	0.5402689	94,079.72
9	1,74,135	0.5002490	87,110.85
10	3,01,435	0.4631935	1,39,622.73
TOTAL			1,227,424.56

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $1,227,424.56 - $794,200

= $433,224.56

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.