Question

CF Estimation. Stanton Inc. is considering the purchase of a new machine which will increase earnings before depreciation and taxes by $6,000 annually. Stanton will use the straightline method to depreciate the machine down to zero, and it expects to sell the machine at the end of its 5-year operating life for $10,000 before taxes. Stanton’s marginal tax rate is 40%, and it uses 9% cost of capital to evaluate projects of this type. If the net cost of the machine is $40,000, what is the project’s NPV? Hint: depreciation is $8,000 per year.

Answer 1

Time line		0	1	2	3	4	5
Cost of new machine		-40000
=Initial Investment outlay		-40000
Profits			6000	6000	6000	6000	6000
-Depreciation	Cost of equipment/no. of years		-8000	-8000	-8000	-8000	-8000
=Pretax cash flows			-2000	-2000	-2000	-2000	-2000
-taxes	=(Pretax cash flows)*(1-tax)		-1200	-1200	-1200	-1200	-1200
+Depreciation			8000	8000	8000	8000	8000
=after tax operating cash flow			6800	6800	6800	6800	6800
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						6000
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							6000
Total Cash flow for the period		-40000	6800.00	6800.0000	6800.00	6800	12800
Discount factor=	(1+discount rate)^corresponding period	1	1.09	1.1881	1.295029	1.4115816	1.538624
Discounted CF=	Cashflow/discount factor	-40000	6238.53211	5723.423954	5250.847664	4817.2914	8319.1217
NPV=	Sum of discounted CF=	-9650.78