Question

The X Company will use a 0.10 discount rate in evaluating an investment that costs $1,500,000. For each year of its 15-year life, the investment will have the following same revenues and out-of-pocket expenses. The firm uses straight-line depreciation. The first year’s income statement is:

Revenues 280,000

out of pocket expenses 30,000

interest 150,000

Depreciation Expense 100,000

Income 0

The company has a zero tax rate. Should the company undertake the investment?

Answer 1

In the above case we can decide whether the company should undertake the investment by using Net Present Value (NPV) Method. Under NPV method Cash inflows of the company means Depreciation added with Profit After Tax (PAT). But when the tax rate is zero Depreciation needed not be considered while computing cash inflows because the net effect will be same that of considering depreciation (PAT+Depreciation).

Step 1: computation of cash inflows (without considering depreciation)

Particulars Amount($)

Revenue. 2,80,000

Less: out of pocket expenses (30,000)

Earnings Before Interest and Tax 2,50,000

Less: Interest expense (1,50,000)

Profit Before Tax 1,00,000

Less: Tax (nil)

Profit After Tax 1,00,000

The cash inflows of the investment for the first year is $ 1,00,000 which is same for all the years during the life of investment.

Step 2: computation of present value of cash out flows.

Present Value of cash outflows = Initial investment or cost = $ 15,00,000

Step 3: computation of present value of cash inflows

Annual Cash inflows= $ 1,00,000 (as computed above)

Present Value Annuity Factor (PVAF) = (1 - (1+r)^ -n) / r

r = Discount rate ( Rate of return)

n = Number of years (period)

PVAF at 0.10 discount rate for 15 years =

= ( 1 - (1+0.10) ^ -15) / 0.10

= ( 1 - 0.23939 ) / 0.10

= 7.606

Note : we can use annuity table to obtain PVAF without using the above formula.

Present Value of cash inflows for 15 years = Annual cash inflows * PVAF at 0.10 discount rate

= $ 1,00,000 * 7.606

= $ 760600

Step 4: computation of NPV

NPV = Present Value of total cash inflows - Cash outflows (Initial investment)

= $ 760600 - $ 15,00,000

= $ - 7,39,400

Since the NPV is negative (-739400) the company should not undertake the investment. In any other case where the NPV is positive we can undertake the investment.