Question

Johnny’s Lunches is considering purchasing a new, energy-efficient grill. The grill will cost $39,000 and will be depreciated straight-line over 3 years. It will be sold for scrap metal after 5 years for $9,750. The grill will have no effect on revenues but will save Johnny’s $19,500 in energy expenses. The tax rate is 30%.

Required:

a. What are the operating cash flows in each year?
b. What are the total cash flows in each year?
c. Assuming the discount rate is 10%, calculate the net present value (NPV) of the cash flow stream. Should the grill be purchased?

Answer 1

Time line		0	1	2	3	4	5
Cost of new machine		-39000
=Initial Investment outlay		-39000
								100.00%
Savings			19500	19500	19500	19500	19500
-Depreciation			-13000	-13000	-13000	0	0	0	=Salvage Value
=Pretax cash flows			6500	6500	6500	19500	19500
-taxes	=(Pretax cash flows)*(1-tax)		4550	4550	4550	13650	13650
+Depreciation			13000	13000	13000	0	0
=a. after tax operating cash flow			17550	17550	17550	13650	13650
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						6825
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							6825
b. Total Cash flow for the period		-39000	17550	17550	17550	13650	20475
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331	1.4641	1.61051
Discounted CF=	Cashflow/discount factor	-39000	15954.54545	14504.13223	13185.57476	9323.1337	12713.364
c. NPV=	Sum of discounted CF=	26680.75

Purchase grill as NPV is positive