Question

Rosman Company has an opportunity to pursue a capital budgeting project with a five-year time horizon. After careful study, Rosman estimated the following costs and revenues for the project:

  

Cost of new equipment	$	420,000
Sale of old equipment no longer needed	$	80,000
Annual cash inflows	$	135,000
Working capital needed	$	65,000
Equipment maintenance in each of Years 3 and 4	$	20,000

The new piece of equipment mentioned above has a useful life of five years and zero salvage value. The old piece of equipment mentioned above would be sold at the beginning of the project and there would be no gain or loss realized on its sale. Rosman uses the straight-line depreciation method for financial reporting and the CCA rate for tax purposes is 20%. The company’s tax rate is 30% and its after-tax cost of capital is 12%. When the project concludes in five years the working capital will be released for investment elsewhere within the company.

Required:
1.	Compute the net present value of this investment opportunity. (Round your PV factor to 4 decimal places and all the other calculations to nearest whole dollar.)

2.	Would you recommend that the contract be accepted?
	Yes No

Answer 1

Year	0	1	2	3	4	5	NPV
	Amount($)	Amount($)	Amount($)	Amount($)	Amount($)	Amount($)
Cost of equipment	-4,20,000
working capital	-65,000
Sale of old equipment	80,000
Annual cash inflows		1,35,000	1,35,000	1,35,000	1,35,000	1,35,000
Manitenance costs				-20,000	-20,000
Depreciation(20% cost)		-84,000	-84,000	-84,000	-84,000	-84,000
Profit before tax		51,000	51,000	31,000	31,000	51,000
tax @ 30%		-15,300	-15,300	-9,300	-9,300	-15,300
Income after Tax		35,700	35,700	21,700	21,700	35,700
Depreciation (non cash expense)		84,000	84,000	84,000	84,000	84,000
Recovery of working capital						65,000
Net cash flow	-4,05,000	1,19,700	1,19,700	1,05,700	1,05,700	1,84,700
Discount Factor @12%	1	0.893	0.797	0.712	0.636	0.567
PV of cash flows	-4,05,000	1,06,892	95,401	75,258	67,225	1,04,725	44,502
Note: as the old machine has been sold at no profit no gain there will be no tax expense or tax advantage on selling the machine
Depreciation = 420000/5 = $84000 per year
Maintenace costs are revenue expenditures and hence deducted from sales to arrive at the taxable net profit
2.Would you recommend that the contract be accepted?
Yes, NPV is positive