Question

Chapter 3 P1:

Stephen Company is evaluating a capital investment proposal for new office equipment for the current year. The initial investment would require the company to spend $50,000. The equipment would be depreciated on a straight line basis over five years with no salvage value. The company has estimated the before-tax annual cash inflow from the investment to be $15,000. The income tax rate is 40% and all taxes are paid in the year that the related cash flows occur. All cash flows occur at year end.

Determine the NPV of the capital investment proposal at 15%, the desired after-tax rate of return. Should the proposal be accepted or not accepted? Explain.

Answer 1

Depreciation = [cost-salvage value ]/useful life

                  = [50000-0]/5

                  = $ 10000

Income before tax = before tax annual cash inflow - depreciation

                 = 15000 - 10000

                 = 5000

Income after tax = 5000[1-.40] = 3000

Annual cash flow (after tax ) = Income after tax +depreciation

                              = 3000+ 10000

                               = 13000

Present value of annual cash flow =PVA 15%,5* Annual cash flow (after tax)

                  = 3.35216* 13000

                = $ 43578.08

NPV = Present value- Initial investment

       = 43578.08 - 50000

     = - 6421.92

since NPV is negative ,proposal should not be accepted.