Question

Suppose that the initial cost of an investment is $310,000, the present value of tax saving from depreciation is $10,510.53, and the present value after tax terminal value is $185,573.74. If the pretax discount rate is 16%, the marginal tax rate is 28%, what is the break even after-tax net returns if the investment is sold in 3 years?

Answer 1

For break even Present value of cash outflows(PVCO) should be equal to the present value of cash inflows(PVCI).

Now Initial Investment that is PVCO = $310000

Therefore PVCI should be = $310000

PVCI includes Present Value(P.V.) of tax saving on depreciation + P.V.of terminal value + P.V. of after tax net returns for 3 years

Therefore $ 310000 = $10510.53 + $185573.74 + P.V. of after tax net returns for 3 years

So, P.V. of after tax net returns for 3 years = $310000 - $10510.53 - $185573.74

= $113915.73

Now, After tax discount rate would be 16 * ( 1 - tax rate) = 16* ( 1 - 0.28) = 11.52%

• After tax net returns = P.V. of after tax net returns for 3 years / Present Value Interest Factor Annuity @ 11.52% for 3 years

= $113915.73 / 2.42178

= $47038

Therefore break even after tax returns required is $47038 per year .

Note:

Present value interest factor annuity is the sum total of present values of 11.52% for 3 years

that is (0.89670 + 0.80407 + 0.72101) = 2.42178