Question

Fairfax Pizza is considering buying a new oven. The new oven would be purchased today for 17,400 dollars. It would be depreciated straight-line to 2,200 dollars over 2 years. In 2 years, the oven would be sold for an after-tax cash flow of 2,800 dollars. Without the new oven, costs are expected to be 13,700 dollars in 1 year and 15,400 in 2 years. With the new oven, costs are expected to be 3,900 dollars in 1 year and 12,300 in 2 years. If the tax rate is 50 percent and the cost of capital is 7.04 percent, what is the net present value of the new oven project?

Answer 1

Depreciation expense per year = ( Initial cost - salvage value) useful life

Depreciation expense per year = ( 17400 - 2200) 2 = $ 7600

Cost savings from the purchase of new oven in year 1 = $ 13700 - $ 3900 = $ 9800

Cost savings from the purchase of new oven in year 2 = $ 15400 - $ 12300 = $ 3100

Operating cash flow = ( Cost savings - expenses - depreciation) ( 1 - tax rate) + depreciation

Operating cash flow year 1 = ( $ 9800 - $ 7600) ( 1 - 0.50) + $ 7600

Operating cash flow year 1 = $ 8700

Operating cash flow year 2 = ( $ 3100 - $ 7600) ( 1 - 0.50) + $ 7600

Operating cash flow year 2 = $ 5350

Ntet present value = - Initial investment + Present value of operating cash flows in year 1 and 2 + Present value of after tax salvage value

Net present value of the new oven project = - $ 2158.99 - $ 2159