Question

***Please do not round calculations or the final answers

Kolby's Korndogs is looking at a new sausage system with an installed cost of $910,000. This cost will be depreciated straight-line to zero over the project?s seven-year life, at the end of which the sausage system can be scrapped for $105,000. The sausage system will save the firm $193,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $51,000. Required: If the tax rate is 30 percent and the discount rate is 6 percent, what is the NPV of this project?

Answer 1

The net present value of this project is dependent on various factors. They are historic cost of asset, present value of post tax savings in operating costs due to introduction of the asset ( the sausage system), required additional net working capital, present value of total tax savings on depreciation.

To start with, since it is given that the discount rate is 6%, and useful life of asset is 7 years, we need to calculate the present value factors for all the 7 years, and sum up the same.

Present value factor for year 1 : 1/1.06 = 0.943396

Present value factor for year 2 : 1/1.06/1.06 = 0.889996

Similarly for year 3, it is 1/1.06/1.06/1.06 = 0.8396192, and it is 0.7920936, 0.7472581, 0.7049605 and 0.6650571 respectively for years 4,5,6 and 7. The cumulative present value factor = sum of all above PV factors = 5.5823805.

Depreciation per annum = (910000-105000)/7 = 115000. Therefore, tax savings on depreciation = 115000*(100-30)% = 34500

NPV CALCULATION

Total Annual operating cost savings post tax ( 193000*(100-30)%*5.5823805) = 754180

Add: Present value of Scrap amount to be received after 7 years (105000*0.6650571) = 69831

Add : Present value of total tax savings on depreciation = 34500*5.5823805 = 192592

Less: Historical cost of asset = 910000

Less: Increaase in Working capital = 51000

Therefore, NPV = 754180+69831+192592-910000-51000 = 55603.