Question

Company XYZ is considering investing in a new machine that will cost $15,000. The machine will allow the firm to generate sales of $50,000 per year. The machine will have a life of 3 years. The operating expenses of XYZ are projected to be 70% of total sales. The machine will be depreciated on a straight-line basis to a zero salvage value. The market value of the machine in three years is estimated to be $5,000. The marginal tax rate of the firm is 35%. If the discount rate is 20%, should the investment be undertaken?

Answer 1

Should the investment be undertaken or not, it will depend on the Net Present value.
Net Present Value is the present value of cash flow from such investment.It is a measure of proposals.
Step-1:Present value of annual cash flow
Years	1	2	3		Total
Sales	$         50,000	$      50,000	$    50,000
Less:operating expenses@70% of sales	$         35,000	$      35,000	$    35,000
Less:Depreciation expenses	$          5,000	$       5,000	$     5,000
Earning before tax	$         10,000	$      10,000	$    10,000
Less:Tax expenses	$          3,500	$       3,500	$     3,500
Net Profit	$          6,500	$       6,500	$     6,500
add:Depreciation expenses	$          5,000	$       5,000	$     5,000
Cash flow	$         11,500	$      11,500	$    11,500
Discount factor	0.833	0.694	0.579
Present value	$          9,583	$       7,986	$     6,655		$ 24,225
Working;
Depreciaion expenses	=	(Cost-salve Value)/Useful Life
	=	(15000-0)/3
	=	$       5,000
Step-2:Present value of after tax sale of machine
After tax sale value	=	$       5,000	*(1-0.35)
	=	$       3,250
since cost of machine has been depreciated, Book value will be zero and all the sale proceeds will become gain on sale and so all amout is taxed.
Present value of after tax sale proceeds of machine		=	$     3,250	*	0.579
		=	$     1,881
Step-3:Total present value of cash inflow
Present value of annual cash flow		$      24,225
Present value of machine		$       1,881
Total Present value of cash inflow		$      26,105
Step-4:Calculatig Net Present value
Present value of cash inflow		$      26,105
Less:Initial investent		$      15,000
Net Present Value		$      11,105
Since there is positive net present value , investment should be undertaken.