Question

1) Your CEO has asked you to evaluate whether the firm should launch a new product. Information provided by the consultant is as follows:

• $20,000 has been spent on doing a market survey, and this cost has been incurred regardless of whether the project is done or not

• Initial investment: $120,000 composed of $50,000 for the plant and $70,000 net working capital (NWC)

• Profits of $32,000 every year for 3 years after which the project ends and NWC is recovered; no salvage value for the plant

For a discount rate of 9%, what is the NPV?

2) You are analyzing the prospects of installing cost saving machinery. You have the following information:

• The machinery will cost $72,000 and will be depreciated straight line (equal amounts) over 4 years

• The machinery will save $32,000 a year

• The machinery will occupy space that would otherwise have been rented for $10,000 a year (before taxes deducted)

• The tax rate is 40%

Hint:

First calculate the net increase in income to be taxed taking into account savings, depreciation and opportunity cost of rentable space. What will be the increase in taxes per year from installing the machinery? (Your answer should be a positive number.)

3) On a yearly basis the machinery generated a savings of $38,000 which led to an increase in taxes of $4,400. The space used by the machinery was lost, leading to loss of rent (post tax) of $8,000.

Hint:

Here you don't need to know Depreciation (which is needed for calculating taxes) or the tax rate. You are told what the taxes are.

What will be the net increase in cash flows per year from installing the machinery?

Answer 1

Question 1:

The NPV can be calculated with the use of following formula:

NPV = -Initial Investment + Cash Flow Year 1/(1+Discount Rate)^1 + Cash Flow Year 2/(1+Discount Rate)^2 + Cash Flow Year 3/(1+Discount Rate)^3

Substituting values in the above formula, we get,

NPV = -120,000 + 32,000/(1+9%)^1 + 32,000/(1+9%)^2 + (32,000 + 70,000)/(1+9%)^3 = $15,054.27

_____

Question 2:

The value of increase in taxes per year is determined as below:

Increase in Taxes Per Year = Net Increase in Income*Tax Rate

where Net Increase in Income = (Annual Savings - Annual Depreciation Rate - Opportunity Cost of Rental Space) = 32,000 - 72,000/4 - 10,000 = $4,000 and Tax Rate = 40%

Substituting these values in the above formula, we get,

Increase in Taxes Per Year = 4,000*40% = $1,600

_____

Question 3:

The net increase in cash flows per year from installing the machinery is calculated as below:

Net Increase in Cash Flows Per Year = Annual Savings - Taxes - Loss of Rent

Substituting values in the above formula, we get,

Net Increase in Cash Flows Per Year = 38,000 - 4,400 - 8,000 = $25,600