Question

Fairfax Pizza is considering buying a new oven. The new oven would be purchased today for 19,400 dollars. It would be depreciated straight-line to 1,400 dollars over 2 years. In 2 years, the oven would be sold for an after-tax cash flow of 2,200 dollars. Without the new oven, costs are expected to be 12,200 dollars in 1 year and 18,500 in 2 years. With the new oven, costs are expected to be -1,600 dollars in 1 year and 14,400 in 2 years. If the tax rate is 50 percent and the cost of capital is 7.92 percent, what is the net present value of the new oven project?

Answer 1

Time line		0	1	2
Cost of new machine		-19400
=Initial Investment outlay		-19400
					100.00%
Savings=	Cost without machine-cost with machine		13800	4100
-Depreciation	(Cost of equipment-salvage value)/no. of years		-9000	-9000	1400
=Pretax cash flows			4800	-4900
-taxes	=(Pretax cash flows)*(1-tax)		2400	-2450
+Depreciation			9000	9000
=after tax operating cash flow			11400	6550
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)			2200
+Tax shield on salvage book value	=Salvage value * tax rate			700
=Terminal year after tax cash flows				2900
Total Cash flow for the period		-19400	11400	9450
Discount factor=	(1+discount rate)^corresponding period	1	1.0792	1.16467264
Discounted CF=	Cashflow/discount factor	-19400	10563.38	8113.86794
NPV=	Sum of discounted CF=	-722.752