Question

Mark Pharmaceutical Company may buy DNA-testing equipment costing $50,000. Mark spends $50,000 to do more researching on the DNA-testing equipment and 10,000 for installation. Suppose that 6 percent inflation in savings from labor costs is expected over the last four years, so that savings in the first year are $20,000, savings in the second year are $21,200, and so forth. The equipment has a useful life of five years but falls in the three-year property class for cost recovery (depreciation) purposes using the MACRS depreciation percentages. If working capital of $10,000 were required in addition to the cost of the equipment and this additional investment were needed over the life of the project. The estimated final salvage value of the new equipment is $20,000 is expected at the end of the fifth year. The corporate tax rate for Mark (combined federal and state) is 38 percent, and its required rate of return is 15 percent. (If profits after taxes on the project are negative in any year, the firm will offset the loss against other firm income for that year.) On the basis of this information, what are the relevant cash flows?

Answer 1

Tax rate		38%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3	Year-4	Year-5	Total
Cost (50000+50000+10000)		$       110,000	$      110,000	$       110,000	$       110,000	$      110,000
Dep Rate		33.33%	44.45%	14.81%	7.41%	0.00%
Depreciation	Cost * Dep rate	$         36,663	$        48,895	$         16,291	$           8,151	$                -	$       110,000
Calculation of after-tax salvage value
Cost of machine			$      110,000
Depreciation			$      110,000
WDV	Cost less accumulated depreciation	$                -
Sale price			$        20,000
Profit/(Loss)	Sale price less WDV	$        20,000
Tax	Profit/(Loss)*tax rate	$          7,600
Sale price after-tax	Sale price less tax		$        12,400
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3	Year-4	Year-5
Contribution		$         20,000	$        21,200	$         22,472	$         23,820	$        25,250
Less: Depreciation		$         36,663	$        48,895	$         16,291	$           8,151	$                -
Profit before tax (PBT)		$       (16,663)	$       (27,695)	$           6,181	$         15,669	$        25,250
Tax@38%	PBT*Tax rate	$         (6,332)	$       (10,524)	$           2,349	$           5,954	$          9,595
Profit After Tax (PAT)	PBT - Tax	$       (10,331)	$       (17,171)	$           3,832	$           9,715	$        15,655
Add Depreciation	PAT + Dep	$         36,663	$        48,895	$         16,291	$           8,151	$                -
Cash Profit after-tax		$         26,332	$        31,724	$         20,123	$         17,866	$        15,655
Calculation of NPV
						15.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor, 1/(1+r)^time	Present values
0		$     (110,000)	$       (10,000)		$     (120,000)	1.0000	$     (120,000)
1				$         26,332	$         26,332	0.8696	$         22,897
2				$         31,724	$         31,724	0.7561	$         23,988
3				$         20,123	$         20,123	0.6575	$         13,231
4				$         17,866	$         17,866	0.5718	$         10,215
5		$         12,400	$        10,000	$         15,655	$         38,055	0.4972	$         18,920
					Net Present Value	$       (30,748)