Question

2 Gateway Communications is considering a project with an initial fixed asset cost of $2.46 million, which will be depreciated straight-line to a zero book value over the 10-year life of the project. At the end of the project, the equipment will be sold for an estimated $300,000. The project will not directly produce any sales but will reduce operating costs by $725,000 a year. The tax rate is 35 percent. The project will require $45,000 of inventory which will be recouped when the project ends. Should this project be implemented if the firm requires a 14 percent rate of return? Why or why not?

Answer 1

Given the project Cost = $ 2.46 Million

Life of the project = 10 Year

Depriciation with 0 book value at the end of the life of the asset = Project Cost / Life of the asset

Therefrore Depriciation per Annum = 2460000/10 = $ 246000

Now Savings in Tax on account of depriciation = Depriciaton per Annum * Tax Rate

Therefore Depriciation Tax Shield (A) = $ 246000 * 0.35 = $ 86100

Now Each year savings in operating Cost = $ 725000

Post Tax Savings (B) = $ 725000 * (1- Tax Rate) = $ 725000 * (1-0.35) = $471250

Now Savings in Operating Cash Flow = A + B = $ 86100 + $ 471250 = $ 557350

Now Let us compute the terminal value of the project

Book Value at the end of 10 Years = $ 0

Sale Proceeds of the machine at the end of 10 th Year = $ 300000

Now, Post Tax Realization = Sales Proceeds - (Sales - Book Value) * (Tax Rate)

Therefore Post Tax Sales cash inflow = $ 300000 - ($ 300000 - $ 0) * 0.35 = $ 195000

Now let us analyze the cash flows of the project:-

Cash Flow Analysis
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Purchase Price	-2460000
Increase in Working Capital	-45000										45000
Terminal Value as computed											195000
Post Tax Savings in Operating Cash Flow		557350	557350	557350	557350	557350	557350	557350	557350	557350	557350
Net Cash Flows of the project (A)	-2505000	557350	557350	557350	557350	557350	557350	557350	557350	557350	797350
Discount Factor @ 14% (B)	1	0.87719298	0.76946753	0.67497152	0.59208028	0.51936866	0.45558655	0.39963732	0.35055905	0.30750794	0.26974381
Present Value of Cash Flows (C= B*A)	-2505000	488904	428863	376195	329996	289470	253921	222738	195384	171390	215080

Summation of All the computed Present Values From Year 1 to Year 10 (D)= $ 2971941

Initial Investment as computed in Year 0 (E) = 2505000

Decision wheather to impliment the project or not will be based on the benifit derived > the cost of the project. Or in other terms the NPV of the project should be positive

NPV = (D) -(E)

NPV = 466941.

Since the NPV of the project is positive the project should be implimented.