Question

16-3)  Litchfield Design is evaluating a 3-year project that would involve buying a new piece of equipment for 430,000 dollars today. The equipment would be depreciated straight-line to 20,000 dollars over 2 years. In 3 years, the equipment would be sold for an after-tax cash flow of 26,000 dollars. In each of the 3 years of the project, relevant revenues are expected to be 302,000 dollars and relevant costs are expected to be 130,000 dollars. The tax rate is 50 percent and the cost of capital for the project is 12.64 percent. What is the NPV of the project?

Answer 1

Depreciation per year = [ ($430,000 - $20,000) / 2 ] = $205,000

Tax on gain on sale = ($26,000 - $20,000) x 50% = $3000

Salvage value net of tax = $26000 - $3000 = $23000

Cash Flows

Particulars	Year 1	Year 2	Year 3
Revenues	$302,000	$302,000	$302,000
Less: Costs	$130,000	$130,000	$130,000
Less: Depreciation	$205,000	$205,000	0
Earnings before tax	(-)$33,000	(-)$33,000	$172,000
Less: Tax @50%	(-)$16,500	(-)$16,500	$86,000
Net Income	(-)$16,500	(-)$16,500	$86,000
Add: Depreciation	$205,000	$205,000	0
Add: Salvage value net of tax			$23,000
Cash Inflows	$188,500	$188,500	$109,000
[email protected]%	0.8877840909	0.78816059206	0.69971643471
Present value of cash inflows	$167,347.30	$148,568.27	$76,269.09

NPV = Total present value of cash inflows - Initial investment = $392,184.66 - $430,000 = (-)$37,815.34

Note : PVIF = present value interest factor of $1 = 1 / (1 + r)ⁿ

where, r is the cost of capital of 12.64% and n being the year for which it is calculated.