Question

A proposed project requires an initial investment in fixed asset of $1,200,000 and is depreciated straight-line to zero over its 3-year life. The project is expected to generate sales of $1,500,000 per year. It has annual fixed costs of $200,000 and annual variable costs of $400,000. The required rate of return on the project is 20 percent. The relevant tax rate is 25 percent. At the end of the project (i.e., year 3) the asset can be sold for $500,000 (before taxes). In addition, the project requires a net working capital of $200,000 at the beginning of the project and will be recouped at the end of the project. Calculate the project’s net present value (NPV). Should the project be accepted?

Answer 1

Tax rate		25%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3			Total
Cost		$    1,200,000	$   1,200,000	$    1,200,000
Dep Rate		33.33%	33.33%	33.33%
Depreciation	Cost * Dep rate	$       400,000	$      400,000	$       400,000			$       1,200,000
Calculation of after-tax salvage value
Cost of machine			$   1,200,000
Depreciation			$   1,200,000
WDV	Cost less accumulated depreciation	$                -
Sale price			$      500,000
Profit/(Loss)	Sale price less WDV	$      500,000
Tax	Profit/(Loss)*tax rate	$      125,000
Sale price after-tax	Sale price less tax		$      375,000
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3
Sale		$    1,500,000	$   1,500,000	$    1,500,000
Less: Operating Cost		$       400,000	$      400,000	$       400,000
Contribution		$    1,100,000	$   1,100,000	$    1,100,000
Less: Fixed cost		$       200,000	$      200,000	$       200,000
Less: Depreciation		$       400,000	$      400,000	$       400,000
Profit before tax (PBT)		$       500,000	$      500,000	$       500,000
Tax@25%	PBT*Tax rate	$       125,000	$      125,000	$       125,000
Profit After Tax (PAT)	PBT - Tax	$       375,000	$      375,000	$       375,000
Add Depreciation	PAT + Dep	$       400,000	$      400,000	$       400,000
Cash Profit after-tax		$       775,000	$      775,000	$       775,000
Calculation of NPV
						20.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor, 1/(1+r)^time	Present values
0		$ (1,200,000)	$     (200,000)		$ (1,400,000)	1.0000	$(1,400,000.00)
1				$       775,000	$       775,000	0.8333	$     645,833.33
2				$       775,000	$       775,000	0.6944	$     538,194.44
3		$       375,000	$      200,000	$       775,000	$    1,350,000	0.5787	$     781,250.00
					Net Present Value	$     565,277.78
Since NPV is positive, the project should be accepted.