Question

ADM Co. is planning to purchase a new bottle-corking line for $200,000. The machine falls under the 3-year MACRS category. ADM’s CFO estimates that the company’s EBDT for the next four years will be as follows:

Year 1: $100,000

Year 2: $115,000

Year 3: $95,000

Year 4: $55,000

ADM’s cost of capital is 12% and the company is in the 25% tax bracket.

Hint: determine the annual depreciation, then calculate the cash flow for each year, then determine the PV of the cash flows.

1. What is the proposed investment project’s NPV
2. Should ADM invest in the bottle-corking line?

Answer:

(a) $

(b)

Answer 1

a)Net Present Value (NPV)=PV of inflows -Initial outflow

Initial investment =$200,000 MACRS 3 year class

Year 1 depreciation=33.33%*200,000=$66,660 Year 2 =44.45%*200,000=$88,900 Year 3 =14.81%*200,000=$29,620 Year 4 =7.41% *200,000=$14,820

After Tax inflows =Change in revenue+/- change in expense +/-tax depreciation charges +/-taxes+/-tax depreciation charges

EBDT for year1 given as $100,000 less tax depreciation $66,660 =33,340 less tax @25%=$8335 we get net effect after tax =$25,005 add back tax depreciation $66,660 we get after tax inflow =$91,665

EBDT for year2 given as $115,000 less tax depreciation $88,900 =26,100 less tax @25%=$6525 we get net effect after tax =$19,575 add back tax depreciation $88,900 we get after tax inflow =$108,475

EBDT for year3 given as $95,000 less tax depreciation $29,620 =$65,380 less tax @25%=$16345 we get net effect after tax =$49,035 add back tax depreciation $29,620 we get after tax inflow =$78,655

EBDT for year4 given as $55,000 less tax depreciation $14,820 =40,180 less tax @25%=$10,045 we get net effect after tax =$30,135 add back tax depreciation $14,820 we get after tax inflow =$44,955

Cost of Capital =12%

Total Pv of inflows =$91,665*.8929=$81,847.6785 + $108,475*.7972=$86476.27 +$78,655*.7118=$55,986.629 +$44,955*.6355=$28,568.90 Total Pv of inflows =$252,879.4775

NPV =$252,879.4775-$200,000=$52,879.4775

b)Yes ADM should invest in the bottle corking line since it has a positive NPV which implies that it would add value to the firm.