Question

A two-year project has been evaluated and has an NPV on an after tax basis of -$2000. On reviewing the analysis the Finance Manager found that depreciation had been omitted from the tax analysis. The allowable depreciation for tax purposes is $5000 for each year. Using a tax rate of 30% and and a discount rate after tax of 12% pa, determine the correct NPV for the project (to the nearest dollar).

Can someone help me to solve this and explain the method to me?

Thanks!

Answer 1

We are already given the NPV of the project without adjustments. What we will do now is calculate the Present Value of the depreciation expense for both years and add the value to the given NPV to arrive at the correct NPV.

Now, the depreciation expense is 5000, which is tax deductible. So after factoring in the tax shield provided by the depreciation expense, the depreciation is 5000 x (1-Tax Rate) = 5000(1-0.3) = 3500

This will be the depreciation expense for both the years. Since it an expense, it will have a negative impact on the NPV of the project. We will take the Present Value of this expense for each year using the following formula:

, where

FV = Expense in the future

r = Discount Rate

t = Time

Plugging in the values we get:

For Year 1, PV = 3500/(1+0.12)¹

= 3125

For Year2, PV = 3500/(1+0.12)²

= 2800

So the Total Present Value of depreciation is 3125+2800 = $5925

Therefore the correct NPV = -2000-5925 = -$7925