Question

IBC, Inc. is considering the purchase of a $320,000 computer that has an economic life of 5 years. The computer will be depreciated according to 5-year MACRS schedule (20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%). The market value of the computer will be $60,000 in 5 years. The use of computer will save annual costs of $120,000 for the next five years. For simplicity, these cost savings are assumed to occur at the end of these years. As a result of this project, the net working capital will increase by $60,000 immediately, and it will be recovered at the end of year 5. The firm’s tax rate is 40% and its cost of capital is 12%. | What is the initial investment requirement (t=0)? What is the operating cash for one, two, three and four and five years? How much tax is the firm expected to pay when the asset is sold for $60,000 in year 5?

What is the project's NPV?

Answer 1

1. Intially Requirement (t=0)

= Cost of Computer + Increase in Working Capital = $ 320,000 + $ 60,000

= $ 380,000

2. Operating Cash Flows ( Amount in $ )

Year/Particulars

1

2

3

4

5

Savings in Cost

120,000

120,000

120,000

120,000

120,000

Depreciation

64,000

81,920

33,423

16,204

14,337

Earnings Before Interest & Tax

56,000

38,080

86,577

103,796

105,663

Tax @ 40 %

22,400

15,232

34,631

41,519

42,265

Net Income	33,600	22,848	51,946	62,278	63,398
Depreciation	64,000	81,920	33,423	16,204	14,337
Operating Cash Flows	97,600	104,768	85,369	78,481	77,735

3. Tax Expected to pay when the asset is sold for $60,000

Depreciation schedule.

YEAR	OPENING	DEPRECIATION	CLOSING
1	320,000	64,000	256,000
2	256,000	81,920	174,080
3	174,080	33,423	140,657
4	140,657	16,204	124,453
5	124,453	14,337	110,116

Closing Book Value = $ 110,116

Sale Value $ 60,000

Since there is a loss of $ 50,116 ( $60,000- 110,116) on sale , firm is not required to pay any tax.

4. PROJECT NPV

Year 0 1 2 3 4 5

a)Initial Outflow -380,000

b)Operating Cash Flows 97,600 104,768 85,369 78,481 77,735

c)Salvage Value 60,000

d)Working Capital Recovery 60,000

e)Total Cash flows -380,000 97,600 104,768 85,369 78,481 197,735

(a+b+c+d)

f)PVF@ 12% 1 0.893 0.797 0.712 0.636 0.567

g)Present Value -380,000 87,143 83,520 60,764 49,876 112,200

(e x g)

Net Present Value = -380,000 + 87,143 + 83,520 + 60,764 + 49,876 + 112,200 = $ 13,504