Question

Dog Up! Franks is looking at a new sausage system with an installed cost of $475,000. This cost will be depreciated straight-line to zero over the project's 5 year life, at the end of which the sausage system can be scrapped for $65,000. The sausage system will save the firm $145,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $28,000. If the tax rate is 24 percent and the discount rate is 12 percent, what is the NPV of this project? (Do not round intermediate calculations and round your answer to 2 decimal places)

Answer 1

The cost of machinery is $475,000 depreciated to zero over 5 years. So, the annual depreciation using straight line method would be $95,000 (475,000/5). Depreciation is a non cash expenses and so it would not involve any cash inflow or outflow. Although, since it will be deducted from pretax profit, it will cause a reduction is taxes that the firm needs to pay. This is called depreciation tax shield. So, the amount in taxes that the firm will end up saving as a result of this depreciation amount is 95000*0.24 = $22,800.

Now, the pre tax cost savings amount to $145,000. We must calculate post tax savings which is equal to 145,000*(1-0.24) = $110,200

The scrap value of $65,000 at the end of 5 years would also attract tax. After tax cash flow as a result would be $65,000*(1-0.24) = $49,400

So, the aggregate cash flow schedule and the resulting NPV calculation is as shown below: