Question

A special power tool for plastic products costs $400,000 and has a 4-year useful life, no salvage value, and a 2-year before-tax payback period. Assume uniform annual end-of-year benefits.

(a) Compute the before-tax rate of return.

(b) Compute the after-tax rate of return, based on MACRS depreciation and a 22.98% combined corporate income tax rate

Answer 1

(a)

Since payback period is 2 years,

Annual benefit ($) = 400,000 / 2 = 200,000

Before-tax rate of return (ROR) is computed using Excel IRR function as follows.

Year	Cash Flow ($)
0	-4,00,000
1	2,00,000
2	2,00,000
3	2,00,000
4	2,00,000
ROR =	34.90%

(b)

Working notes:

(i) MACRS schedule as follows (MACRS GDS recovery period for Plastic Production - Power tools is 3 years).

Year	Cost ($)	Depreciation Rate (%)	Annual Depreciation ($)
	(A)	(B)	(C) = (A) x (B)
1	4,00,000	58.33	2,33,320
2	4,00,000	27.78	1,11,120
3	4,00,000	12.35	49,400
4	4,00,000	1.54	6,160

(ii) Pre-tax income = Annual benefit - Depreciation

(iii) After-tax income = Pre-tax income x (1 - Tax rate) = Pre-tax income x (1 - 0.2298) = Pre-tax income x 0.7702

(iv) After-tax cash flow (ATCF) = After-tax income + Depreciation

After-tax rate of return (ROR) of the ATCF is computed using Excel IRR function as follows.

Year	Benefit ($)	Depreciation ($)	Pre-tax Income ($)	After-tax Income ($)	ATCF ($)
	(D)	(C)	(E) = (D) - (C)	(F) = (E) x 0.7702	(F) = (C) + (F)
0	-4,00,000				-4,00,000
1	2,00,000	2,33,320	-33,320	-25,663	2,07,657
2	2,00,000	1,11,120	88,880	68,455	1,79,575
3	2,00,000	49,400	1,50,600	1,15,992	1,65,392
4	2,00,000	6,160	1,93,840	1,49,296	1,55,456
				After-tax ROR =	29.32%