Question

Downhill Pizza, located near the Sugarloaf ski area, makes Tuscan style “homemade” pizza which it freezes and distributes throughout the northeast. It is considering a new more efficient pizza oven with a larger capacity. The installed cost will be $290,000. This cost will be depreciated straight line over its five year life to a zero salvage value as determined by the IRS (there is no half-year convention with straight line depreciation). However, the firm plans to sell the oven in four years (at t = 4) for $65,000. The oven will save the firm $110,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $28,000 which will be returned to the firm at the end of the project (at t=4). There are no other net working capital changes. If the tax rate is 28% and the project discount rate is 14%, what is the NPV of this project?

Answer 1

Given :

tax rate = 28%

discount rate =  14%

cost of new oven = $290,000

initial investment in working capital = $28,000

pre-tax savings per year =$110,000

selling price of oven at yr 4 = $65,000

we compute,

total initial investment = cost of oven + working capital = 290000 + 28000 = $318,000

depreciation per year = 290,000/5 = $58,000

tax per year = (pre-tax saving - depreciation) * (1- tax rate)

= (110000-58000)* (1-0.28)

= $37,440

post tax saving per year = pre tax saving - tax = 110000 - 37440 = $72,560

book value of oven = initial cost - depreciation for 4 years = 290000 - (58000 * 4 ) = 290000 - 232000

= $58,000

profit from sale of oven = selling price - book value = 65000 - 58000 = $7,000

tax on profit from sale of oven = 7000 * 0.28 = $1,960

post tax income from sale of asset = selling price - tax on sale =  65000 - 1960 = $ 63040.

NPV = initial investment - present value of post tax savings of all years - present value of post tax income from sale of assets - present value of working capital recovered at end of yr 4.

therefore

therefore NPV = $-52678