Question

In: Finance

Lander Company has an opportunity to pursue a capital budgeting project with a five-year time horizon....

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.

Solutions

Expert Solution

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)

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