Question

Lander Company has an opportunity to pursue a capital budgeting project with a five-year time horizon. After careful study, Lander estimated the following costs and revenues for the project:

Cost of equipment needed	$	310,000
Working capital needed	$	68,000
Repair the equipment in two years	$	22,000
Annual revenues and costs:
Sales revenues	$	430,000
Variable expenses	$	220,000
Fixed out-of-pocket operating costs	$	96,000

The piece of equipment mentioned above has a useful life of five years and zero salvage value. Lander uses straight-line depreciation for financial reporting and tax purposes. The company’s tax rate is 30% and its after-tax cost of capital is 13%. When the project concludes in five years the working capital will be released for investment elsewhere within the company

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. Calculate the annual income tax expense for each of years 1 through 5 that will arise as a result of this investment opportunity.

2. Calculate the net present value of this investment opportunity. (Negative amounts should be indicated by a minus sign. Round your final answer to nearest whole dollar.)

Answer 1

Here, a special explanation of treatement of Repair expenses is to be considered. Repair of machine is a revenue expenditure which restores its decreased utility but does not increase its capacity or utility. Hence such expenses are written off against the sales revenue of the year in which such expenses are incurred.

Hence tax expenses will change for year - 2 only. Since repair expenses are incurred in year - 2 only.

Thus tax expenses will be Year - 1 15600, Year - 2 will be 9000 and for each of Year - 3 , 4 and 5 tax expenses will be 15600 per year.

	Year - 1	Year - 2	Year 3.4&5
Sales revenues	430000	430000	430000
(-) Variable expenses	220000	220000	220000
Contribution	210000	210000	210000
(-) Fixed cost ( cash expenses)	96000	118000	96000
Income before Depreciation	114000	92000	114000
(-) Depreciation	62000	62000	62000
Income before tax	52000	30000	52000
Tax expenses	15600	9000	15600

NPV OF THE INVESTMENT OPPURTUNITY

Year	CF	DF	PV
0	-310000	1	-378000
1	98400	0.88496	87079.65
2	83000	0.78315	65001.17
3	98400	0.69305	68196.14
4	98400	0.61332	60350.56
5	166400	0.54276	90315.25
		NPV	- 7057.23

CF = cash flows are calculated as under

	Year - 1	Year - 2	Year - 3	Year - 4	Year - 5
Income before tax	52000	30000	52000	52000	52000
(-) Tax expenses @ 30% of above	15600	9000	15600	15600	15600
Profit after tax	36400	21000	36400	36400	36400
(+) Depreciation ( 310000 / 5 years)	62000	62000	62000	62000	62000
(+) Working capital recovery					68000
Net Cash flow	98400	83000	98400	98400	166400