Question

Pablito is interested in starting a store.
To supplement the equipment you already have, you need to purchase a small truck that costs $ 20,000 and that qualifies for depreciation for 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 you need to make a loan for $ 10,000, which will be repaid according to the amortization schedule shown in the table.

	year	Balance Beginning Year	Accumulated Interest, 9%	Cumulative total	Annual payment	Final balance
	0					12,000
	1	12,000	1080.00	13,080	$3,704.02	$9,375.98
	2	9,376	843.84	10,220	$3,704.02	$6,515.79
	3	6,516	586.42	7,102	$3,704.02	$3,398.19
	4	3,398	305.84	3,704	$3,704.02	$0.00
3	6,516	586.42	7,102	$3,704.02	$3,398.19
4	3,398	305.84	3,704	$3,704.02	$0.00

Generate the table detailing the after-tax analysis of this investment alternative. Apply an effective tax rate of 35%. You must show your calculations in detail to get credit.

After completing your analysis, calculate the measure of merit (decision criterion) that you would use to explain to pablito if this is a good investment. Write a sentence with the recommendation I would give you. Assume a 15% MARR after tax.

Answer 1

the measure of merit (decision criterion) that you would use to explain to pablito if this is a good investment is net present value (NPV). If NPV is positive then it's a good investment.

NPV = sum of present value of cash flows - cost of truck

sum of present value of cash flows = Year 1 cash flow/(1+MARR) + Year 2 cash flow/(1+MARR)2 + Year 2 cash flow/(1+MARR)3 .... + Year 6 cash flow/(1+MARR)6

Tax on resale value of truck is: (resale value - book value)*tax rate

book value at the end of the project is zero. so, tax on resale value of truck is: $3,000*35% = $1,050‬

MACRS 3-year depreciation rates are: Year 1 - 33.33%, Year 2 - 44.45%, Year 3 - 14.81% and Year 4 - 7.41%

Interest on loan taken is not needed in cash flow calculation because it's included in after-tax MARR of 15% as cost of debt. so, if we include interest on loan in cash flow calculation then it would be double counting.

NPV is $5,564.37. so, it's a good investment for pablito because it will generate profits.

	Years	0	1	2	3	4	5	6	Total
	Cost of truck	-$20,000	0	0	0	0	0	0	-$20,000
	Annual income	$0	$10,000	$10,000	$10,000	$10,000	$10,000	$10,000	$60,000
Less:	Oper. & Main. Expenses	$0	$1,500	$1,800	$2,100	$2,400	$2,700	$3,000	$13,500
Less:	Depreciation	$0	$6,666	$8,890	$2,962	$1,482	$0	$0	$20,000
	Pre-tax cash flow	$0	$1,834	-$690	$4,938	$6,118	$7,300	$7,000	$26,500
Less:	Taxes @35%	$0	$642	-$242	$1,728	$2,141	$2,555	$2,450	$9,275
	After-tax cash flow	$0	$1,192	-$449	$3,210	$3,977	$4,745	$4,550	$17,225
Add back:	Depreciation	$0	$6,666	$8,890	$2,962	$1,482	$0	$0	$20,000
Add:	Resale value of truck	$0	$0	$0	$0	$0	$0	$3,000	$3,000
Less:	Tax on resale value	$0	$0	$0	$0	$0	$0	$1,050	$1,050
	Operating cash flow	-$20,000	$7,858	$8,442	$6,172	$5,459	$4,745	$6,500	$19,175
	NPV	$5,564.37

Calculations