Question

Dog Up! Franks is looking at a new sausage system with an installed cost of $296,400. This cost will be depreciated straight-line to zero over the project's 4-year life, at the end of which the sausage system can be scrapped for $45,600. The sausage system will save the firm $91,200 per year in pretax operating costs, and the system requires an initial investment in net working capital of $21,280.

  

If the tax rate is 25 percent and the discount rate is 12 percent, what is the NPV of this project?

Answer 1

Initial Investment for the Project

Initial Investment for the Project = Cost of the asset + Working capital needed

= $296,400 + $21,280

= $317,680

Annual Operating Cash Flow (OCF)

Annual Operating Cash Flow (OCF) = Pretax Savings(1 – Tax Rate) + (Depreciation x Tax Rate)

= [$91,200(1 – 0.25)] + [($296,400 / 4 Years) x 0.25]

= [$91,200 x 0.75] + [$74,100 x 0.25]

= $68,400 + $18,525

= $86,925

Year 1-3 Cash flow = $86,925

Year 4 Cash flow = Annual operating cash flow + After-Tax Salvage value + Release of working capital

= $86,925 + [$45,600(1 – 0.25)] + $21,280

= $86,925 + $34,200 + $21,280

= $142,405

Net Present Value of the Project

Period	Annual Cash Flow ($)	Present Value factor at 12%	Present Value of Cash Flow ($)
1	86,925	0.892857	77,611.61
2	86,925	0.797194	69,296.08
3	86,925	0.711780	61,871.50
4	1,42,405	0.635518	90,500.95
TOTAL			2,99,280.13

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $2,99,280.13 - $317,680

= -$18,399.87 (Negative NPV)

“Therefore, the Net Present Value (NPV) of the Project would be -$18,399.87 (Negative NPV) “

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.