Question

Dog Up! Franks is looking at a new sausage system with an installed cost of $733,200. This cost will be depreciated straight-line to zero over the project's 7-year life, at the end of which the sausage system can be scrapped for $112,800. The sausage system will save the firm $225,600 per year in pretax operating costs, and the system requires an initial investment in net working capital of $52,640.

  

Required:

If the tax rate is 32 percent and the discount rate is 15 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

= $733,200 + $52,640

= $785,840

Annual Operating Cash Flow (OCF)

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

= [$225,600 x (1 – 0.32)] + [($733,200 / 7 Years) x 0.32]

= [$225,600 x 0.68] + [$104,743 x 0.32]

= $153,408 + $33,518

= $186,926

Year 1-6 Cash flow = $186,926

Year 7 Cash flow = Annual operating cash flow + After-Tax Salvage value + Release of working capital

= $186,926 + $52,640 + [$112,800 x (1 – 0.32)]

= $186,926 + $52,640 + [$112,800 x 0.68]

= $186,926 + $52,640 + $76,704

= $316,270

Net Present Value of the Project

Period	Annual Cash Flow ($)	Present Value factor at 15%	Present Value of Cash Flow ($)
1	1,86,926	0.8695652	1,62,544.10
2	1,86,926	0.7561437	1,41,342.70
3	1,86,926	0.6575162	1,22,906.69
4	1,86,926	0.5717532	1,06,875.38
5	1,86,926	0.4971767	92,935.12
6	1,86,926	0.4323276	80,813.14
7	3,16,270	0.3759370	1,18,897.50
TOTAL			8,26,314.63

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

= $826,314.63 - $785,840

= $40,474.63

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.