Question

Bottoms Up Diaper Service is considering the purchase of a new industrial washer. It can purchase the washer for $7,200 and sell its old washer for $2,100. The new washer will last for 6 years and save $1,700 a year in expenses. The opportunity cost of capital is 14%, and the firm’s tax rate is 21%.

a. If the firm uses straight-line depreciation over a 6-year life, what are the cash flows of the project in years 0 to 6? The new washer will have zero salvage value after 6 years, and the old washer is fully depreciated. (Negative amounts should be indicated by a minus sign.)

b. What is project NPV? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

c. What is NPV if the firm investment is entitled to immediate 100% bonus depreciation? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

=> Initial investment is given as $ 7,200, Salvage value of old washer is given as $ 2,100, useful life of new washer = 6 years, savings in expense = $ 1,700, opportunity cost of capital = 14% and tax rate = 21%.

a)

=> In year 0, there is a initial investment of $ 7,200 (cash outflow) and the old washer is sold for $ 2,100 (cash inflow). But we have to pay 21% tax on it:

* After tax salvage value of old washer = 2,100 * (1 - 0.21) = $ 1,659

* Cash flow in year 0 = Cash inflow - Cash outflow = 1,659 - 7,200 = - $ 5,541

=> From year 1 to year 6, we can find the Cash flow by using the formula (Tax shield approach):

* Here there is no revenue ($0), savings in expense = $ 1,700 ( So expense = - $ 1,700), Tax rate is 21% and we have to find the value of depreciation:

* Now we have all the values just plug into the formula:

* Therefore the cash flows from year 1 to year 6 is $ 1,595

b)

=> Now, we have the all the cash flows and can easily find the Net Present Value (NPV) of the project.  

=> Therefore, NPV of the project is $ 661.42

Formula used in excel:

c)

=> Here in year 0 , we have 100% bonus depreciation, We know the cash flow in year 0 (part a) = - 5,541

* We have to add the bonus depreciation tax savings in year 0 that is:

Depreciation * Tax rate = 7,200 * 0.21 = 1,512

* Therefore cash flow in year 0 = - 5,541 + 1,512 = $ - 4,029

=> From year 1 to year 6, there is no depreciation expense:

* Therefore the cash flows in year 1 to year 6 = [ 0 - (-1,700) ] * (1 - 0.21) = 1,700 * 0.79 = $ 1,343

=> Now we know all the cash flows and can find the NPV now:

=> Therefore, the NPV if the firm investment is entitled to immediate 100% bonus depreciation = $ 1,193.48

Formula used in excel: