Question

You must evaluate the purchase of a proposed piece of equipment. The cost of the equipment is $50,000. The installation and transportation cost of bringing the equipment to its location is $6,000. The equipment falls into the MACRS 3-year class. The project is expected to increase revenues by $80,000 each year and increase operating costs (excluding depreciation) by $30,000 each year. This project leads to an increase in net operating working capital by $10,000. You can salvage the equipment for $10,000 at the end of the project. What is the project's cash flow in Years 1, 2, 3, 4? (use MACRS of 33%, 45%, 15%, 7%). Use the NPV and IRR criteria to evaluate this project. Is this project profitable? Use marginal tax rate of 21% and WACC of 10%.

Answer 1

It is assumed that working capital is returned in year 4 along with salvage value and annual cash flows.

NPV is:

Ref	Particulars		Year 1	Year 2	Year 3	Year 4
a	Operating cash flow		$       30,000.00	$               30,000.00	$   30,000.00	$   50,000.00
b	Depreciation		$       18,480.00	$               25,200.00	$     8,400.00	$     3,920.00
c=a-b	Profit before tax		$       11,520.00	$                 4,800.00	$   21,600.00	$   46,080.00
	Less: taxes		$         2,419.20	$                 1,008.00	$     4,536.00	$     9,676.80
	Profit after tax		$         9,100.80	$                 3,792.00	$   17,064.00	$   36,403.20
	Add: depreciation		$       18,480.00	$               25,200.00	$     8,400.00	$     3,920.00
	Cash flow after tax		$       27,580.80	$               28,992.00	$   25,464.00	$   40,323.20
d	Present value factor@ 10.0%		0.909090909	0.826446281	0.751314801	0.683013455
e=c*d	Present value of annual cashflows		$       25,073.45	$               23,960.33	$   19,131.48	$   27,541.29
	Total present value of annual cash inflows		$       95,706.55
	Less: investment		$       56,000.00
	NPV		$       39,706.55
	IRR		38.02%

NPV is positive and IRR is more than WACC.

Project is accepted.