Question

A proposed cost saving investment has a five year life and an installed cost of $800,000. The depreciation schedule for the equipment is three year MACRS for which the annual factors are .333, .4445, .1481, .0741. The equipment has an estimated salvage value in year 5 of $65,000 before taxes. The company's required return on cost saving investments is 12% and its tax rate of 35%. The company expects to borrow the funds neccesary to make the investment and pay the interest at the rate of 7%. The loan will be interest only for five years with the repayment of principal at the end of the life of the project. A net working capital investment of $50,000 will be required immediatley and 50% of that will be recovered at the end of the third year of the project life. The balance of the NWC will be recovered at the end of year five. Management believes that the annual cost savings will be either $100,000 or $400,000 dpending on wether the economy is weak (40%) or stron (60%) for the next five years. An expected cost of the project is that the manager of the project will hire an assistant who will cost $45,000 per year before taxes for the first three years of the project. In the last two years of the project, the assistant will not be needed for the project and may be laid off or promoted to another project, depending on the need in the company for their skill set. Calculate the net present value of this project, then state wether the company should invest?

Answer 1

Loan amount = 800000+50000

= 850000

interest amt. per year = 850000*7%

= 59500 per year

cost saving per year = 100000*40% + 400000*60%

= 40000 + 240000

= 280000

Calculation of Present value from the project -

	MACRS Rate	0.333	0.4445	0.1481	0.0741
	Year	1	2	3	4	5	NPV
	Revenue	280000	280000	280000	280000	280000
less	Dep.(cost of assets * MACRS rate)	266400	355600	118480	59280	0
less	Cost of assistant	45000	45000	45000
less	Interest cost	59500	59500	59500	59500	59500
	EBIT	-90900	-180100	57020	161220	220500
less	income tax @ 35%	0	0	19957	56427	77175
	EAT	-90900	-180100	37063	104793	143325
add	Net working capital recovered			25000		25000
add	salvage value after tax 65000*(1-t)					42250
add	Depriciation	266400	355600	118480	59280	0
	Repayment of principal loan					-850000
	Cash flow after tax	175500	175500	180543	164073	-639425
	Discounting @ 12%	0.892857	0.797194	0.71178	0.635518	0.567427
	Net present value	156696.4	139907.5	128506.9	104271.4	-362827	166555.3

The initial investment would be 0 as all the invested amount has been taken on loan which would be repaid at the end of the life of the project/5th year.

According to the present value method, the company should invest in this project as NPV is coming positive.