Question

Your firm is contemplating the purchase of a new $850,000 inventory control system. The system will be depreciated using bonus depreciation over its four-year life.  It will be worth $75,000 at the end of that time.  You believe that the inventory control system will allow you to increase sales by $250,000 per year but cost will go up by $40,000 per year.  Also, you will have to increase net working capital by $90,000 at the beginning of the project.  Net working capital will revert back to normal at the end of the project.  In addition, the tax rate is 25 percent.  Suppose your required return on the project is 13 percent, will you accept the project?

a.   What is the depreciation each year?

b.   What is the OCF each year?

c.    What is the after-tax salvage valu3 of the project year?

d.   What is the NPV for the project?

Answer 1

PART A - DEPRECIATION EACH YEAR

Under Bonus depreciation, 100% bonus depreciation is allowed to be deducted in the first year from September 27, 2017 until January 1, 2023.

Thus Bonus depreciation will be as follows-

Year 1 = 100% of ($850,000) = $850,,000

Year 2, Year 3 & Year 4 = $0

PART B- OPERATING CASH FLOW EACH YEAR (before tax)

Operating cash flow each year = Increase in sales - Increase in cost

=$250,000 - $40,000 = $210,000

PART C- AFTER TAX SALVAGE VALUE OF THE PROJECT YEAR

Salvage value of the project (before tax) = $75,000

Salvage value of the project (after tax) = $75,000 * 0.75 = $56,250

PART D - NPV of the project

Year	Cash flow after tax	PVF @ 13%	PV
a	b	e	f=d*e
0	-$940,000.00	1.000	-$940,000.00
1	$351,250.00	0.885	$310,840.71
2	$157,500.00	0.783	$123,345.60
3	$157,500.00	0.693	$109,155.40
4	$281,250.00	0.613	$172,495.89
		NPV	-224162.397

NOTES:-

1) Cash flow of Year 0 = - (Purchase cost + increase in working capital) = - $850,000- $90,000= - $940,000

2)Cash flow of Year 1 = [(Increase in sales- increase in cost +depreciation) * (1-tax rate)] + Depreciation

3) cash flow of year 3 = ( Increase in sales- increase in cost ) * (1 - tax rate)

4) cash flow of year 4 = (Increase in sales- increase in cost +Salvage value + recovery of working capital) * (1-tax rate)