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If Lew's Steel Forms purchases $618,000 of new equipment, they can lower annual operating costs by...

If Lew's Steel Forms purchases $618,000 of new equipment, they can lower annual operating costs by $265,000. The equipment will be depreciated straight-line to a zero book value over its 3-year life. Ignore bonus depreciation. At the end of the three years, the equipment will be sold for an estimated $60,000. The equipment will require the company to hold an extra $23,000 of inventory over the 3-year period. What is the NPV if the discount rate is 14 percent and the tax rate is 21 percent?

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Expert Solution

Cost of equipment = $618000, Initial investment in working capital = Investment in inventory = $23000

Cash flow in year 0 = - Cost of equipment - Initial investment in working capital = - 618000 - 23000 = -641000

Since the equipment will depreciated on straight line basis to zero over 3 years, Hence Book value of equipment at end of 3 years = 0, Depreciable life = 3

Annual depreciation = (Cost of equipment - Book value of equipment at end of 3 years) / Depreciable life = (618000 - 0) / 3 = 618000 / 3 = 206000

Incremental revenue from equipment = 0

Since the equipment lowers the operating expenses, incremental operating expenses = -265000

After tax operating cash flow for year 1 to 3 = (incremental revenue - incremental operating costs - depreciation)(1-tax rate) + depreciation = [0-(-265000) - 206000][1-21%] + 206000 = [0+265000 - 206000][1-21%] + 206000 = 59000 x 79% + 206000 = 46610 + 206000 = 252610

Terminal cash flow in year 3 = Salvage value of equipment at end of 3 years - Tax on gain from sale of equipment + Recovery of investment in net working capital

= Salvage value of equipment at end of 3 years - tax rate(Salvage value of equipment at end of 3 years - Book value of equipment at end of 3 years) + Recovery of investment in net working capital

= 60000 - 21%(60000 - 0) + 23000 = 60000 - 12600 + 23000 = 70400

NPV = Cash flow in year 0 + Sum of present values of after tax operating cash flow for year 1 to 3 + Present value of Terminal cash flow = -641000 + 252610 / (1+14%) + 252610 / (1+14%)2 + 252610 / (1+14%)3 + 70400 / (1+14%)3

= -641000 + 221587.7192 + 194375.1923 + 170504.5547 + 47517.9947 = -7014.5391 = -7014.54(rounded to two decimal places)

Therefore NPV = - 7014.54

jeff jeffy answered 1 year ago
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