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%.

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

2. b) What is the Net Present Value (NPV) of this project? SHOW ALL WORK FOR FULL CREDIT USING THE TI BAII PLUS CALCULATOR.

3. c) What is the Internal Rate of Return (IRR)? SHOW ALL WORK FOR FULL CREDIT USING THE TI BAII PLUS CALCULATOR.

Answer 1

Here is the solution :

a) Table of the cash flows

> Initial Cash flow = Equipment Cost

                             = $ 5.2 Mn Answer

> Operating Cashflow

- Depreciation Calculation

Particulars	Year 1	Year 2	Year 3	Year 4
Depreciation	=5200000*33% = 1716000	=5200000*45% = 2340000	=5200000*15% = 780000	=5200000*7% = 364000

- Operating cashflows calculation

Particulars	Year 1	Year 2	Year 3	Year 4
Cash Inflows	2000000	2000000	2000000	2000000
Less : Depreciation	-1716000	-2340000	-780000	-364000
Profit before tax	284000	-340000	1220000	1636000
Less : Tax @ 21%	-59640	71400*	-256200	-343560
Profit After Tax	224360	-268600	963800	1292440
Add: Depreciation	1716000	2340000	780000	364000
After tax Cash flow	1940360	2071400	1743800	1656440

> Terminal cash flow = Salvage value of the equipment

                                  = $ 40000

b) Net Present Value (NPV)

> Present Value of cash inflow

Year	Cash flows	Present value Factor	Present Value
1	1940360	0.9091	1763981
2	2071400	0.8264	1711805
3	1743800	0.7513	1310117
4	1656440	0.6830	1131349
4 - Terminal	40000	0.6830	27320
		Total	5944572

> NPV = PVCI - Initial Investment

              = 5944572 - 5200000

              = $ 744572

c) Internal rate of return is the rate where present value of cash inflow is equal to the initial investment.

> 5200000 = Present value of cash inflows

Table at different rates

Year	Cash flows	Present value @ 16%	Present Value @ 17%
1	1940360	1672724	1658427
2	2071400	1539388	1513186
3	1743800	1117179	1088777
4	1656440 + 40000	936929	905305
	Total	5266220	5165695

Thus, IRR lies between 16 and 17 %. (Interpolation is algebric method to put the values and find the missing one)

By interpolation we get the IRR = 16.66 %

Hope you understand the solution.