Question

Kolby’s Korndogs is looking at a new sausage system with an installed cost of $655,000. This cost will be depreciated straightline to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $85,000. The sausage system will save the firm $183,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $35,000. If the tax rate is 22 percent and the discount rate is 8 percent, what is the NPV of this project?

Answer 1

Initial Investment Cost for the Project

Initial Investment for the Project = Cost of the asset + Working capital needed

= $655,000 + $35,000

= $690,000

Annual Operating Cash Flow (OCF)

Annual Operating Cash Flow (OCF) = Pretax Savings(1 – Tax Rate) + (Depreciation x Tax Rate)

= [$183,000 x (1 – 0.22)] + [($655,000 / 5 Years) x 0.22]

= [$183,000 x 0.78] + [$131,000 x 0.22]

= $142,740 + $28,820

= $171,560

Year 1-4 Cash flow = $171,560

Year 5 Cash flow = Annual operating cash flow + Release of working capital -After-Tax Salvage value

= $171,560 + $35,000 + [$85,000 x (1 – 0.22)]

= $171,560 + $35,000 + [$85,000 x 0.78]

= $171,560 + $35,000 + $66,300

= $272,860

Net Present Value of the Project

Year	Annual cash flows ($)	Present Value Factor (PVF) at 8.00%	Present Value of annual cash flows ($) [Annual cash flow x PVF]
1	1,71,560	0.9259259	1,58,851.85
2	1,71,560	0.8573388	1,47,085.05
3	1,71,560	0.7938322	1,36,189.86
4	1,71,560	0.7350299	1,26,101.72
5	2,72,860	0.6805832	1,85,703.93
TOTAL		7,53,932.41

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $753,932.41 - $690,000

= $63,932.41

“Hence, the NPV for this Project will be $63,932.41”

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)n], Where “r” is the Discount/Interest Rate and “n” is the number of years.