Question

Management is contemplating the purchase of a new oven which cost $25,000.00 with an estimated salvage value of zero. Expected before tax cash savings from the new oven are $4,000 a year over its full depreciable life. Depreciation is computed using straight line over a 5 year life, and the cost of capital is 10%. At the end of the oven's life, it can be sold for 2,000. Assume a 40% tax rate.

What is the net present value of the new oven? IRR?

Answer 1

Cost of Equipment = $25,000
Useful Life = 5 years

Annual Depreciation = Cost of Equipment / Useful Life
Annual Depreciation = $25,000 / 5
Annual Depreciation = $5,000

Annual OCF = Before-tax Cost Saving * (1 - tax) + tax * Annual Depreciation
Annual OCF = $4,000 * (1 - 0.40) + 0.40 * $5,000
Annual OCF = $4,400

Salvage Value = $2,000
After-tax Salvage Value = $2,000 * (1 - 0.40)
After-tax Salvage Value = $1,200

Cash Flows:

Year 0 = -$25,000
Year 1 = $4,400
Year 2 = $4,400
Year 3 = $4,400
Year 4 = $4,400
Year 5 = $4,400 + $1,200
Year 5 = $5,600

Answer a.

Cost of Capital = 10%

NPV = -$25,000 + $4,400/1.10 + $4,400/1.10^2 + $4,400/1.10^3 + $4,400/1.10^4 + $5,600/1.10^5
NPV = -$7,575.43

Answer b.

Let IRR be i%

NPV = -$25,000 + $4,400/(1+i) + $4,400/(1+i)^2 + $4,400/(1+i)^3 + $4,400/(1+i)^4 + $5,600/(1+i)^5
0 = -$25,000 + $4,400/(1+i) + $4,400/(1+i)^2 + $4,400/(1+i)^3 + $4,400/(1+i)^4 + $5,600/(1+i)^5

Using financial calculator, i = -2.36%

So, IRR is -2.36%