Question

Dave is a medical device distributor in Nevada and runs his business as a sole proprietor.

He therefore pays taxes on his business income as part of his individual income tax filing.

Currently his effective tax rate is 37.9% ( 35% federal income tax rate plus 2.9% Medicare tax

rate - there is no state income tax in Nevada which is why he moved there from California).

He has recently been made aware of a new technology that can be used during surgery that

more effectively controls blood loss. Deployment of this technology would require purchasing

additional equipment and employing a couple of technicians to use the equipment at local

hospitals. He is seeking your advice on whether he should adopt this technology from a

financial perspective. The initial investment in the equipment would be $900,000. The

machine would operate for eight years, after which the machine would be worthless and Dave

is expecting to retire. In each of those eight years, he expects to generate revenue of $900,000

and have an operating margin of 19% (employee expenses and materials would run 81% per

year). He would depreciate the machine for tax purposes using straight-line depreciation over

the eight years. There would also be an initial investment in working capital of $135,000

which would be fully recovered at the end of the eighth year.

If Dave makes this investment, his tax rate will be 37.9% and the required return will be 5%. What is the NPV of this project?

Answer 1

A). Initial investment   is $1,035,000

Initial investment = cost of initial investment + increase in Net working

1. initial fixed assets investment = $900,000

2.increase in Net working capital = $135,000

cash flow (year 0) = (900,000 + 135,000) = $1,035,000

B). Yearly operating Cash Flow is $1,562,724

Yearly operating Cash Flow
Annual revenue	900,000.00
operating profit (19% of revenue)	171,000.00
Depreciation (900,000 / 8)	(112,500.00)
Earnings before tax	58,500.00
Taxes (37.9%)	(22,171.50)
Earnings after tax	36,328.50
Add Non-cash expenses(depreciation)	112,500.00
Yearly operating Cash Flow	148,828.50

D). NPV of the project if we end the project after 3 years is 18284

CALCULATIONS: -

Year	0	1	2	3	4	5	6	7	8
initial fixed assets investment	-900,000
increase in Net working capital	-135,000
Yearly operating Cash Flow		148,829	148,829	148,829	148,829	148,829	148,829	148,829	148,829
recovered Net working capital									135000
Total cash flows	-1,035,000	148,829	148,829	148,829	148,829	148,829	148,829	148,829	283,829
PV of $1 Factor for 5%	1	0.952	0.907	0.864	0.823	0.784	0.746	0.711	0.677
Discounted Cash Flow	-1035000	141741.429	134992	128564	122442	116611	111058	105770	192106
sum of discounted cash flows from year I to 8 =1053284

NPV = PV of future expected net cash inflows – initial investment

Initial investment = 1,035,000

NPV=   1053284 – 1,035,000

NPV = 18284