Question

Lander Company has an opportunity to pursue a capital budgeting project with a five-year time horizon. After careful study, Lander estimated the following costs and revenues for the project:

Cost of equipment needed	$	380,000
Working capital needed	$	75,000
Repair the equipment in two years	$	25,500
Annual revenues and costs:
Sales revenues	$	500,000
Variable expenses	$	255,000
Fixed out-of-pocket operating costs	$	110,000

The piece of equipment mentioned above has a useful life of five years and zero salvage value. Lander uses straight-line depreciation for financial reporting and tax purposes. The company’s tax rate is 30% and its after-tax cost of capital is 11%. When the project concludes in five years the working capital will be released for investment elsewhere within the company

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. Calculate the annual income tax expense for each of years 1 through 5 that will arise as a result of this investment opportunity.

2. Calculate the net present value of this investment opportunity.

Answer 1

	Working Notes -
1)	Depreciation = Cost of Equipment / No of Years
	= $380000 / 5
	= $76000
2)	Present Value Factor = 1 / (1+r)n
	Where,
	r = After Tax cost of Capital = 11% = 0.11
	n = No of Years
	So,
	For Year 1 = 1/(1+r)n = 1/(1+0.11)1 = 1/1.11 = 0.9009
	For Year 2 = 1/(1+r)n = 1/(1+0.11)2 = 1/1.2321 = 0.8116
	For Year 3 = 1/(1+r)n = 1/(1+0.11)3 = 1/1.367631 = 0.7312
	For Year 4 = 1/(1+r)n = 1/(1+0.11)4 = 1/1.518070 = 0.6587
	For Year 5 = 1/(1+r)n = 1/(1+0.11)5 = 1/1.685058 = 0.5935
3)	Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
A.	Sales Revenue Per Year	$500,000	$500,000	$500,000	$500,000	$500,000
B.	Less : Variable Expenses	$255,000	$255,000	$255,000	$255,000	$255,000
C.	Less : Fixed Out of Pocket Operating Cost	$110,000	$110,000	$110,000	$110,000	$110,000
D.	Less : Repair the Equipment	-	$25,500	-	-	-
E.	Less: Depreciation (As per Working Note 1)	$76,000	$76,000	$76,000	$76,000	$76,000
F.	Add: Release of Net Working Capital	-	-	-	-	$75,000
G.	Profit Before Tax [A-B-C-D-E+F]	$59,000	$33,500	$59,000	$59,000	$134,000
H.	Tax @ 30% [ Profit Before Tax*Tax Rate = G*30%]	$17,700	$10,050	$17,700	$17,700	$40,200
I.	Profit After Tax [Profit Before Tax - Tax = G-H]	$41,300	$23,450	$41,300	$41,300	$93,800
J.	Operating Profit After Tax	$117,300	$99,450	$117,300	$117,300	$169,800
	[Profit After Tax+Depreciation = I+E]
K.	Present Value Factor (As per Working Note 2)	0.9009	0.8116	0.7312	0.6587	0.5935
L.	Present Value of Operating Profit After Tax
	[Operating Profit After Tax * Present Value Factor = J*K]	$105,675.57	$80,713.62	$85,769.76	$77,265.51	$100,776.30
	Now,
a)	Annual Income Tax Expense (As per Working Note 3 Point No (G)
	Year 1 = $17700
	Year 2 = $10050
	Year 3 = $17700
	Year 4 = $17700
	Year 5 = $40200
b)	Net Present Value = (-Initial Investment) + Present Value of Operating Profit After Tax for all 5 Years
	= (-Cost of Equipment- Working Capital) + Present Value of Operating Profit After Tax for all 5 Years
	= (-$380000-$75000)+$105675.57+$80713.62+$85769.76+$77265.51+$100776.30
	= (-$4799.24)