Question

The ICan’tBelieveWhat’sHappening Company needs to decide whether or not to purchase a new piece of equipment. The equipment costs $5.2 million (payable now). The equipment will provide before-tax cash inflows of $2.0 million a year at the end of each of the next four years. The equipment would be categorized as a 3-year tax class asset according to the MACRS system. Therefore use the following depreciation rates: 33%, 45%, 15%, and 7%, for each year respectively from year 1 through 4.

At the end of four years, the company expects to be able to sell the equipment for a salvage value of $ 40,000 (after-tax). The company is in the 21% tax bracket. The company has an after-tax cost of capital of 10%.

a) Show the initial cash outflow, operating cash flows, and terminal cash flow.

b) What is the Net Present Value (NPV) of this project? Show work from the required

calculator.

c) What is the Internal Rate of Return (IRR)? Show work from the required calculator.

Answer 1

a) initial cash outflow is $5.2 million which is cost of equipment at year 0.

Operating cash flow = [(before-tax cash inflow - depreciation)*(1-tax rate)] + depreciation

Depreciation will be calculated as below:

Depreciation = cost of equipment*depreciation rate

Depreciation year 1 = $5,200,000*33% = $1,716,000‬

Depreciation year 2 = $5,200,000*45% = $2,340,000‬

Depreciation year 3 = $5,200,000*15% = $780,000

Depreciation year 4 = $5,200,000*7% = $364,000‬

Operating cash flow year 1 = [($2,000,000 - $1,716,000‬)*(1-0.21)] + $1,716,000‬ = ($284,000*0.79) + $1,716,000 = $224,360 + $1,716,000 = $1,940,360

Operating cash flow year 2 = [($2,000,000 - $2,340,000‬)*(1-0.21)] + $2,340,000‬ = (-$340,000‬*0.79) + $2,340,000 = -$268,600‬ + $2,340,000 = $2,071,400

Operating cash flow year 3 = [($2,000,000 - $780,000‬)*(1-0.21)] + $780,000‬ = ($1,220,000‬*0.79) + $780,000 = $963,800‬ + $780,000 = $1,743,800‬

Operating cash flow year 4 = [($2,000,000 - $364,000‬‬)*(1-0.21)] + $364,000‬‬ = ($1,636,000‬*0.79) + $364,000‬ = $1,292,440‬ + $364,000‬ = $1,656,440‬

Terminal value is salvage value of $40,000 (after-tax) by selling the equipment in year 4.

so, total cash flow in year 4 will be $1,656,440‬ + $40,000 = $1,696,440‬

b) & c) NPV & IRR using financial calculator

Press CF and 2ND key in the calculator and then press CE/C key to clear CF register. now you'll see CF0= 0.00. input -5,200,000 initial cash outflow and press enter and then down arrow key.

in C01 input 1,940,360 operating cash flow of year 1 and press enter and down arrow key. next you'll see F01= 1.00. leave it as it is and press down arrow key. (F01 is asking for no. of cash flows. as it is only one cash flow, so we will leave it as it is.) now you'll see C02. enter 2,071,400 and press enter followed by down arrow key. next you'll see F02= 1.00. leave it as it is and press down arrow key.

Enter year 3 and 4 cash flow of 1,743,800 and 1,696,440‬ in C03 and C04 and leave F03 as it is. when you get F04= 1.00 then press NPV key. you'll get I = 0.00. input 10 after-tax cost of capital and press enter followed by down arrow key. you'll get NPV= 0.00. press CPT key and you'll get NPV = 744,698.56. now press IRR key and then CPT key. you'll get IRR = 16.66%.

so, NPV = $744,698.56 and IRR = 16.66%.