Question

10.Calculating Salvage ValueAn asset used in a 4-year project falls in the 5-year MACRS class for tax purposes. The asset has an acquisition cost of $7.6 million and will be sold for $1.4 million at the end of the project. If the tax rate is 21 percent, what is the aftertax salvage value of the asset?

11.Calculating NPVThurston Petroleum is considering a new project that complements its existing business. The machine required for the project costs $4.1 million. The marketing department predicts that sales related to the project will be $2.35 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated to zero over its 4-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. The company also needs to add net working capital of $150,000 immediately. The additional net working capital will be recovered in full at the end of the project’s life. The corporate tax rate is 25 percent and the required return for the project is 13 percent. Should the company proceed with the project?

Answer 1

Solution 10:

To find the book value at the end of the four years, we are required to find the accumulated depreciation for the first four years. We get

Book value at the end of year 4 = $7,600,000 - $7,600,000 (0.2000 + 0.3200 + 0.1920 + 0.1150)

Book value at the end of year 4 = $1,314,800

The asset is sold at a gain to book value, so it is taxable.

After-tax salvage value = $1,400,000 + ($1,314,800 - $1,400,000) (0.21)

After-tax salvage value = $1,417,892

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Solution 11:

We will begin by calculating the initial cash outlay, that is, the cash flow at Time 0. T

Equipment –$4,100,000

NWC –150,000

Total –$4,250,000

Using the bottom-up approach to calculating the operating cash flow, we find the operating cash flow each year will be:

Sales $2,350,000

Costs 587,500 ($2,350,000 x 25%)

Depreciation 1,025,000

EBT $737,500

Tax 184,375

Net income $553,125

The operating cash flow is:

OCF = Net income + Depreciation

OCF = $553,125+ 1,025,000

OCF = $1,578,125

To find the NPV of the project, we add the present value of the project cash flows

NPV = –$4,100,000 + $1,578,125 (PVIFA 13%,4) + $150,000 / 1.13^4

NPV = -$4,100,000 + $1,578,125 [(1.13^4-1)/(0.13*1.13^4)] + $150,000/1.13^4

NPV = $686,085.4

Since NPV is positive, the company should proceed with the project.