Question

Med Inc. is considering the purchase of a new equipment to produce face marks. The equipment would be depreciated by the straight-line method over its 4-year life, and would have a $10,000 salvage value. Accounts payable will rise by $5,000 at time 0 but will be recovered at the end of the project’s life. Revenues and annual operating costs are expected to be constant over the project's 4-year life. The other information is shown below.

Risk-adjusted WACC 12.0%

Equipment purchase cost (depreciable basis) $90,000

Sales revenues, each year $50,000

Annual operating costs (excl. depreciation) $20,000

Tax rate 30.0%

a). What is the project's NPV?

b). If the depreciation method is MACRS 3-year class (33%, 45%, 15%, 7%), will the NPV calculated be affected? (Briefly explain. No calculation is required)

Answer 1

a).

Inflow / (outflow)	Year 0	Year 1	Year 2	Year 3	Year 4
Equipement Investment	(90,000)
Equipement Salvage (Sale)					10,000
Change in Accounts payable	(5,000)				5,000
Revenue		50,000	50,000	50,000	50,000
Interest Expense @ 9% on outstanding		(20,000)	(20,000)	(20,000)	(20,000)
Depreciation (1/4 of (90,000 - 10,000) each year)		(20,000)	(20,000)	(20,000)	(20,000)
Profit before tax		10,000	10,000	10,000	10,000
Taxation @ 30%		4,000	4,000	4,000	4,000
Profit after Tax		6,000	6,000	6,000	6,000
Annual cash inflow (PAT+Dep.)		26,000	26,000	26,000	26,000
Cash Inflow / (outflow)	(95,000)	26,000	26,000	26,000	41,000
Discounting Factor @ 12%	1.0000	0.8929	0.7972	0.7118	0.6355
Annual present value of cash flow	(95,000)	23,214	20,727	18,506	26,056
Net Present value	(6,496)

Project NPV is Negative $6,496

b).

NPV calculated above is effected if Change in deprecaition method. As depreciation is not Inflow / (Outflow) of cash but it impact the tax amount year wise. So If depreciation is higher in initial years then tax will be lower in initial year and NPV will be improved (due to discounting factor change yearly).

Although total cash flow will be same but NPV will change.

So when we apply MACRS 3-year class (33%, 45%, 15%, 7%), depreciation is higher in 1st & 2nd year which will increase the NPV.

This can be test by detailed calculation as under:

Inflow / (outflow)	Year 0	Year 1	Year 2	Year 3	Year 4
Equipement Investment	(90,000)
Equipement Salvage (Sale)					10,000
Change in Accounts payable	(5,000)				5,000
Revenue		50,000	50,000	50,000	50,000
Interest Expense @ 9% on outstanding		(20,000)	(20,000)	(20,000)	(20,000)
Depreciation ( (33%, 45%, 15%, 7%) on 90,000)		(29,700)	(40,500)	(13,500)	(6,300)
Profit before tax		300	(10,500)	16,500	23,700
Taxation @ 30%		120	(4,200)	6,600	9,480
Tax on salvage (30% of 10,000)					3,000
Profit after Tax		180	(6,300)	9,900	11,220
Annual cash inflow (PAT+Dep.)		29,880	34,200	23,400	17,520
Cash Inflow / (outflow)	(95,000)	29,880	34,200	23,400	32,520
Discounting Factor @ 12%	1.0000	0.8929	0.7972	0.7118	0.6355
Annual present value of cash flow	(95,000)	26,679	27,264	16,656	20,667
Net Present value	(3,735)

Project NPV is Negative $3,735