Question

A company is considering of purchasing a testing equipment costing $50,000. This equipment is expected to reduce labor costs by $16,000 annually. The equipment has useful life of 5 years, but falls in the 3-year property class for depreciation purpose. No salvage value is expected at the end. The marginal tax rate is 34% and its required after-tax rate of return is 16%.

1.What is the incremental after-tax cash flow for the first year of operation?

2.On the basis of this information, what is your recommendation?(Do nothing, wait another year or purchase the equipment? Or there is not enough information?)

Answer 1

Ref	Particulars		Year 1	Year 2	Year 3	Year 4	Year 5
a	Operating cash flow		$       16,000.00	$               16,000.00	$      16,000.00	$   16,000.00	$   16,000.00
	Gain on sale of asset				$                     -
b	Depreciation		$      (16,665.00)	$             (22,225.00)	$       (7,405.00)	$   (3,705.00)	$                 -
c=a-b	Profit before tax		$           (665.00)	$               (6,225.00)	$         8,595.00	$   12,295.00	$   16,000.00
	Less: taxes		$           (226.10)	$               (2,116.50)	$         2,922.30	$     4,180.30	$     5,440.00
	Profit after tax		$           (438.90)	$               (4,108.50)	$         5,672.70	$     8,114.70	$   10,560.00
	Add: depreciation		$       16,665.00	$               22,225.00	$         7,405.00	$     3,705.00	$                 -
	Cash flow after tax		$       16,226.10	$               18,116.50	$      13,077.70	$   11,819.70	$   10,560.00
d	Present value factor@ 16.0%		0.862068966	0.743162901	0.640657674	0.552291098	0.476113015
e=c*d	Present value of annual cashflows		$       13,988.02	$               13,463.51	$         8,378.33	$     6,527.92	$     5,027.75
	Total present value of annual cash inflows		$       47,385.53
	Less: investment		$       50,000.00
	NPV		$        (2,614.47)

1

Incremental after tax cash flows are $16,226

2

Do nothing as NPV is negative.