Question

A proposed cost-saving device has an installed cost of $660,000. The device will be used in a five-year project but is classified as three-year MACRS (MACRS Table) property for tax purposes. The required initial net working capital investment is $51,500, the marginal tax rate is 34 percent, and the project discount rate is 13 percent. The device has an estimated Year 5 salvage value of $76,500. What level of pretax cost savings do we require for this project to be profitable? Pretax savings $

Answer 1

	The project should have atleast an NPV of 0.
	The present value of known cash flows are:
1]	Installed cost of the device	$            6,60,000
	Increase in NWC	$               51,500
	Initial cost	$            7,11,500
2]	PV of depreciation tax shield [calculations given in table below] =	$            1,77,535
	Year	Depreciation %	Depreciation	Tax shield on depreciation at 34%	PVIF at 13%	PV at 13%
	1	33.33	$         2,19,978	$           74,793	0.88496	$        66,188
	2	44.45	$         2,93,370	$           99,746	0.78315	$        78,116
	3	14.81	$             97,746	$           33,234	0.69305	$        23,033
	4	7.41	$             48,906	$           16,628	0.61332	$        10,198
	PV of depreciation tax shield					$    1,77,535
3]	PV of terminal non-operating cash flows:
	After tax salvage value = 76500*(1-34%) =	$               50,490
	Recapture of net working capital	$               51,500
	Terminal non operating cash flows	$            1,01,990
	PV = 101900/1.13^5 =	$               55,307
4]	For NPV of 0, PV of after tax annual cost savings should be:
	= 711500-177535-55307 =	$            4,78,658
	Annual after tax cost savings = 478658*0.13*1.13^5/(1.13^5-1) =	$            1,36,089
	Annual pre tax cost savings = 136089/(1-34%) =	$            2,06,195	[Minimum]
	CHECK FOR 0 NPV:	0	1	2	3	4	5
	Annual pre tax cost savings = 136089/(1-34%) =		$         2,06,195	$       2,06,195	$    2,06,195	$    2,06,195	$     2,06,195
	Depreciation		$         2,19,978	$       2,93,370	$        97,746	$        48,906	$                  -
	Incremental NOI		$           -13,783	$         -87,175	$    1,08,449	$    1,57,289	$     2,06,195
	Tax at 34%		$              -4,686	$         -29,640	$        36,873	$        53,478	$        70,106
	Incremental NOPAT		$              -9,097	$         -57,536	$        71,576	$    1,03,811	$     1,36,089
	Add: Depreciation		$         2,19,978	$       2,93,370	$        97,746	$        48,906	$                  -
	Incremental OCF		$         2,10,881	$       2,35,835	$    1,69,322	$    1,52,717	$     1,36,089
	Capital expenditure	$            6,60,000
	Change in NWC	$               51,500					$       -51,500
	After tax salvage value = 76500*(1-34%) =						$        50,490
	FCF	$          -7,11,500	$         2,10,881	$       2,35,835	$    1,69,322	$    1,52,717	$     2,38,079
	PVIF at 13% [PVIF = 1/1.13^t]	1	0.88496	0.78315	0.69305	0.61332	0.54276
	PV at 13%	$          -7,11,500	$         1,86,621	$       1,84,693	$    1,17,349	$        93,664	$     1,29,220
	NPV	$                        46
		Almost 0 [Difference due to approximation]