Question

Charlotte Computer Services is considering purchasing equipment at $100 000. It is anticipated the equipment will have a useful life of five years. It will be depreciated on a straight-line basis. Operating revenue is expected to be $74 000 per annum and operating expenses $25 000 per annum. The equipment is subject to an investment allowance of 10 per cent and the tax rate is 30 per cent. The after-tax hurdle rate is 12 per cent.
a) The reduction in tax due to the investment allowance is?
b) What is the tax effect of the depreciation?
c) What is the Net Present Value of the investment?

Answer 1

Solution a:

Total investment allowance = $100,000 * 10% = $10,000

Reduction in tax due to investment allowance = $10,000 *30% =$3,000

Solution b:

Annual depreciation = $100,000 / 5 = $20,000

Tax saving due to depreciation = $20,000 * 30% = $6,000

Therefore annual tax effect of the depreciation = $6,000

Solution c:

Computation of Annual cash flows
Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Operating revenue	$74,000.00	$74,000.00	$74,000.00	$74,000.00	$74,000.00
Operating expenses	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00
Depreciation expense	$20,000.00	$20,000.00	$20,000.00	$20,000.00	$20,000.00
Income before taxes	$29,000.00	$29,000.00	$29,000.00	$29,000.00	$29,000.00
Income tax	$8,700.00	$8,700.00	$8,700.00	$8,700.00	$8,700.00
Income after tax	$20,300.00	$20,300.00	$20,300.00	$20,300.00	$20,300.00
Add: Depreciation	$20,000.00	$20,000.00	$20,000.00	$20,000.00	$20,000.00
Add: Tax saving on investment allowance	$3,000.00
Annual Cash inflows	$43,300.00	$40,300.00	$40,300.00	$40,300.00	$40,300.00

Computation of NPV - Charlotte Computer Services
Particulars	Period	PV Factor	Amount	Present Value
Cash outflows:
Cost of Equipment	0	1	$100,000	$100,000
Present Value of Cash outflows (A)				$100,000
Cash Inflows
Annual increase in Cash Inflows:
Year 1	1	0.892857143	$43,300	$38,661
Year 2	2	0.797193878	$40,300	$32,127
Year 3	3	0.711780248	$40,300	$28,685
Year 4	4	0.635518078	$40,300	$25,611
Year 5	5	0.567426856	$40,300	$22,867
Present Value of Cash Inflows (B)				$147,951
Net Present Value (NPV) (B-A)				$47,951