Question

Your firm is considering a new product development. An outlay of $110,000 is required for equipment, and additional net working capital of $5,000 is required. Implementing the project will generte a time zero investment tax credit benefit of $3,000 for the firm (i.e. at the beginning of the project). The project is expected to have a 4 year life, and the equipment will be depreciated on a straight line basis to a $10,000 book value. Producing the new product will reduce current manufacturing expenses by $20,000 annually and increase earnings (revenue) before depreciation and taxes by $23,000 annually. Stanton's marginal tax rate is 40%. Stanton expects the equipment will have a market salvage value of $15,000 at the end of 4 years.

4. Compute the after tax salvage value of the equipment at the end of 4 years.
5. Compute the total cash flows associated with the analysis of this project and clearly indicate them on a timeline.
6. If the cost of capital fora project at this risk is 9%, what is the project's NPV? Should it be accepted? Accepted or reject the project? Why?

Answer 1

Answer 4
Computation of the after tax salvage value of the equipment at the end of 4 years.
Salvage value of the equipment	$15,000
Less : Book value at the end of 4th year	$10,000
Gain on Sale	$5,000
Tax @ 40%	$2,000
After tax salvage value (Salvage value - Tax)	$13,000
Answer 5
Computation of the total cash flows associated with the analysis of this project
Year	0	1	2	3	4
Equipment Purchase	-$110,000
Additional net working capital	-$5,000
Investment tax credit benefit	$3,000
After tax salvage value of equipment					$13,000
Reduction in manufacturing expenses		$20,000	$20,000	$20,000	$20,000
Tax @ 40% on Reduction in manufacturing expenses		-$8,000	-$8,000	-$8,000	-$8,000
Increase in earnings before depreciation and tax		$23,000	$23,000	$23,000	$23,000
Tax @ 40% on increase in earnings		-$9,200	-$9,200	-$9,200	-$9,200
Depreciation tax shield		$10,000	$10,000	$10,000	$10,000
Net Cash flow associated with the project	-$112,000	$35,800	$35,800	$35,800	$48,800
Depreciation on equipment per year = (Cost - Residual book value) / useful life = ($110000 - $10000)/4 = $25,000
Depreciation tax shield = Depreciation per year * tax rate = $25000 * 40% =
Answer 6
Year	0	1	2	3	4	NPV
Net Cash flow associated with the project	-$112,000	$35,800	$35,800	$35,800	$48,800
Discount Factor @ 9%	1	0.9174312	0.84168	0.7721835	0.7084252
Present Values	-$112,000	$32,844	$30,132	$27,644	$34,571	$13,191
The project should be accepted as it generates the positive NPV.