Question

	Predicted Cash Inflows (outflows) (A)	Year(s) of Cash Flows (B)	12% Present Value Factor (C)	Present Value of Cash Flows (A * C)
Initial Investment
Fixed Assets	($810,000)	0	1	($810,000)
Working Capital	-$100,000.00	0	1	($100,000)
Operations				$0
Annual taxable income without depreciation	310,000	1-5	3.605	$1,117,550
Taxes on income ($310,000*.40)	-124,000	1-5	3.605	($447,020)
Depreciation tax shield	64,800	1-5	3.605	$233,604
Disinvestment				$0
Site restoration	80,000	5	0.567	($45,360)
Tax shield of restoration ($80,000*.40)	32,000	5	0.567	$18,144
Working Capital	100,000	5	0.567	$56,700
Net present value of all cash flows				$23,618

*Computation of depreciation tax shield:

Annual straight-line depreciation ($810,000/5) . . . . . . . . . . . . . . $162,000

Tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 0.40

Depreciation tax shield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 64,800

Because the proposal had a positive net present value when discounted at Sunshine’s cost of capital of 12 percent, the project was approved; all investments were made at the end of 2017. Shortly after production began in January 2018, a government agency notified Sunshine of required additional expenditure totaling $200,000 to bring the plant into compliance with new federal emission regulations. Sunshine has the option either to comply with the regulations by Dec 31, 2018, or to sell the entire operation (fixed assets and working capital) $250,000 on December 31, 2018. The improvements will be depreciated over the remaining four-year life of the plant using straight-line depreciation. The cost of site restoration will not be affected by the improvements. If Sunshine elects to sell the plant, any book loss can be treated as an offset against taxable income on other operations. This tax reduction is an additional cash benefit of selling.

Required – 20 points

a. Should Sunshine sell the plant or comply with the new federal regulations? To simplify calculations, assume that any additional improvements are paid for on December 31, 2018.

b. Would Sunshine have accepted the proposal in 2017 if it had been aware of the forthcoming federal regulations?

c. Do you have any suggestions that might increase the project’s net present value? (No calculations are required.)

Answer 1

	0	1	2	3	4	5
Initial Investment	(810,000)
Working Capital	(100,000)
Annual Taxable Income without depreciation		310,000	310,000	310,000	310,000	310,000
Taxes on Income		(124,000)	(124,000)	(124,000)	(124,000)	(124,000)
Depreciation tax shield		64,800	64,800	64,800	64,800	64,800
Additional Investment		(200,000)
Depreciation tax shield Improvements			20,000	20,000	20,000	20,000
Disinvestment
Site restoration						(80,000)
Tax shiled on restoration						32,000
Working Capital						100,000
Net Cash Inflow/( Outflow)	(910,000)	50,800	270,800	270,800	270,800	322,800
Present Value Factor	1	0.8929	0.7972	0.7118	0.6355	0.567
Net Present value of all cash flow	(910,000)	45,357	215,880	192,750	172,098	183,028	(100,887)
	0	1
Initial Investment	(810,000)
Working Capital	(100,000)
Annual Taxable Income without depreciation		310,000
Taxes on Income		(124,000)
Depreciation tax shield		64,800
Cash receipt from sale of Assets		250,000
Tax Gain from sale of Assets and release of Working Capital
((810000+100000-162000)-250000)*40%		199,200
Net Cash Inflow/( Outflow)	(910,000)	700,000
Present Value Factor	1	0.8929
Net Present value of all cash flow	(910,000)	625,000	(285,000)

Sunshine should comply with the Federal requirements instead of selling the plant. If he sells the plant, he will loose $ 285,000 , however if he continues to run the plant, the loss would be $100,887.

Snshine would have not accepted the offer, had he been aware of the forthcoming Federal regulations since the Net present value of the project was negative.

Project NPV can be increased if the cash inflow increases, it can be achieved if the company can increase its sales revenue, alternatively decreasing the costs of sales can also incrrease the inflow and thereby Net Present value.