Question

Dog Up! Franks is looking at a new sausage system with an installed cost of $400,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $25,000. The sausage system will save the firm $95,000 per year in pretax operating costs. The system also requires an initial investment in net working capital of $15,000, which will be returned in full at the end of the project. If the tax rate is 20 percent and the discount rate is 10 percent, what is the NPV of this project?

Answer 1

Calculation of the depreciation :-

Depreciation = Cost of machine / Life of the machine in years = $ 400,000 / 5 = $80,000 per year

Calculation of the after tax salvage value of machine :-

Here Total depreciation = $ 80000 * 5 = 400,000 = cost of machine

So, here machine is fully depreciated, there is no book value at the time of the sale.

So, total proceeds from the sale is gain.

After tax proceeds from salvage value = gain * ( 1- tax rate) = 25,000 * ( 1 - 0.20) = $ 20,000

Calculation of the initial cash outlay
Cost of machine	$400,000
Add- Working capital	15000
Initial investment	$415,000

Calculation of the operating cash inflows :-

Particulars	Amount
Savings in pre tax operating cost	$95,000
Less- Depreciation	80,000
EBT	$15,000
Less-Tax@20%	$3,000
Profit after tax	$12,000
Add-Depreciation	80,000
Operating cash flows per year	$92,000

Calculation of the present value of cash inflows :-

Years	Operating cash flows	Recovery of WC	After tax salvage value	Total cash flows	PVF@10%	Present value of CF
1	92000			92000	0.909091	83636.36364
2	92000			92000	0.826446	76033.05785
3	92000			92000	0.751315	69120.96168
4	92000			92000	0.683013	62837.23789
5	92000	15000	20000	127000	0.620921	78857.00803
present value of cash inflows	370,484.629

NPV = present value of cash inflows - initial investment = $ 370,484.629 - 415,000 =  (44,515.371)