Question

Steven, a newly graduated chef, is interested in establishing a family business. To supplement the equipment you already have, you need to purchase a commercial refrigerator that costs $ 20,000 and is classified for depreciation purposes as a 3-year MACRS property. The asset is estimated to have a resale value at the end of its six-year useful life of $ 3,000. Operational and maintenance expenses are expected to be $ 1,500 the first year and will increase $ 300 annually from the second year. Uniform annual income of $ 10,000 is expected. In addition, to acquire this alternative, she needs to make a loan of $ 10,000 that will be repaid in four years according to the amortization schedule shown in the table.


Balance Beginning Year |Accumulated Interest 7%| Total Accumulated| Annual Payment| Final Balance
           

				10000
10000	700	10700	$2952.28	$7747.72
7748	542.34	8290	$2952.28	$5337.78
5338	373.64	5711	$2952.28	$2759.14
2759	193.14	2952	$2952.28	$0

Generate the table detailing the after-tax analysis of this investment alternative. Apply an effective tax rate of 30%. You must show your calculations in detail to get credit.

After completing your analysis, briefly explain what measure of merit (decision criteria) you would use to explain to the chef if this is a good investment. Write a sentence with your recommendation. Assume a 15% MARR after tax.

Answer 1

	We shall ignore the loan repaymnets in NPV calculation as MARR takes care of the finance cost
	As the asset has 6 years useful life , considering cash flow for six years
		Year 1	Year 2	Year 3	Year 4
	MACRS depreciation -3 yrs	33.33%	44.45%	14.81%	7.41%
	Refrigerator cost	$           20,000
	salvage value after six years	$             3,000
	Tax rate 30%
	Post Tax salvage value =3000*(1-30%)=	$             2,100

	Cash flow/NPV details	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
1	Investment in Refrigerator	$         (20,000)
	Cash flow from operation
	Revenue		$          10,000	$                   10,000	$             10,000	$              10,000	$               10,000	$            10,000
	Operational & Maint exp		$            1,500	$                     1,800	$               2,100	$                2,400	$                  2,700	$               3,000
	Depreciation		$            6,666	$                     8,890	$               2,962	$                1,482	$                        -	$                     -
	EBT		$            1,834	$                       (690)	$               4,938	$                6,118	$                  7,300	$               7,000
	Tax @30%		$               550	$                       (207)	$               1,481	$                1,835	$                  2,190	$               2,100
	PAT		$            1,284	$                       (483)	$               3,457	$                4,283	$                  5,110	$               4,900
	Add back depreciation		$            6,666	$                     8,890	$               2,962	$                1,482	$                        -	$                     -
2	Cash flow from operations		$            7,950	$                     8,407	$               6,419	$                5,765	$                  5,110	$               4,900
3	Terminal Cash flow
4	Post Tax resale value of refrigerator							$               2,100
5	Total cash flow=1+2+4=	$         (20,000)	$            7,950	$                     8,407	$               6,419	$                5,765	$                  5,110	$               7,000
6	Discount factor @ MARR 15% =1/1.15^n	$                    1	0.870	0.756	0.658	0.572	0.497	0.432
7	PV of cash flows=5*6	$         (20,000)	$            6,913	$                     6,357	$               4,220	$                3,296	$                  2,541	$               3,026
8	NPV =Sum of PV of cash flows=	$             6,353
	Profitability Index=6353/20000=	32%
	As the NPV of the investment is positive , this is a good investment option
	Also the profitability index is quite good. So Steven can go for investing in
	the commercial refrigerator .