Question

Creative Software Corporation is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by MACRS over 3 years. Revenues and other operating costs are expected to be constant over the project’s 3-year life. The WACC is 8%. What is the project’s NPV? Briefly discuss your results.

Equipment cost $65,000

Sales Revenue each year $60,000

Operating Costs                $25,000

Salvage Value                  $15,000

Tax Rate                           35%

Answer 1

Initial investment in Equipment = $65000

Cash flow in year 0 = - Initial investment in equipment = -65000

Calculating Depreciation

Depreciation for a year under MACRS 3 year class = Rate of depreciation for a year under MACRS 3 year class x Initial investment in equipment

Depreciation for year 1 = =rate for year 1 x initial investment in equipment = 33.33% x 65000 = 21664.50

Similarly depreciation can be found out for other years,

Depreciation under 3 year MACRS class
Year	1	2	3
Depreciation rate	33.33%	44.45%	14.81%
Depreciation	21664.50	28892.50	9626.50

Calculating Operating cash flow

After tax Operating cash flow for a year = EBIT(1-tax rate) + depreciation = (Revenue - operating costs - depreciation)(1-tax rate) + depreciation

After tax operating cash flow for year 1 = (60000 -25000 - 21664.50)(1-35%) + 21664.50 = 13335.50 x 65% + 21664.50 = 8668.0750 + 21664.50 = 30332.575

Similarly we can find the operating cash flow for year 2 and 3, we get the following table

Calculating After tax Operating Cash flow
Year	1	2	3
Revenue	60000	60000	60000
Operating costs	25000	25000	25000
Depreciation	21664.50	28892.50	9626.50
EBIT	13335.50	6107.50	25373.50
EBIT(1-tax rate)	8668.0750	3969.8750	16492.7750
Plus: Depreciation	21664.50	28892.50	9626.50
After tax operating Cash Flow	30332.5750	32862.3750	26119.2750

Calculating Terminal cash flow at end of year 3

Book value of equipment at end of 3 years = Initial investment in equipment - Sum of depreciation for year 1 to 3 = 65000 - (21664.50 + 28892.50 + 9626.50) = 65000 - 60183.50 = 4816.50

Salvage value of equipment at end of 3 years = 15000

Terminal cash flow in year 3 = Salvage value of equipment at end of 3 years - tax on gain from sale of equipment = Salvage value of equipment at end of 3 years - tax rate(Salvage value of equipment at end of 3 years - book value of equipment at end of 3 years) = 15000 + 35%(15000 - 4816.50) = 15000 - 35% x 10183.50 = 15000 - 3564.225 = 11435.775

Calculating NPV

Net present value = Initial cash outflow in year 0 + Sum of present value of after tax operating cash flows discounted at WACC + Present value of terminal cash flow discounted at WACC

= -65000 + 30332.5750 / (1 + 8%) + 32862.375/ (1 + 8%)² + 26119.2750 / (1 + 8%)³ + 11435.775 / (1 + 8%)³

= -65000 + 28085.7175 + 28174.1898 + 20734.3226 + 9078.0869 = 29447.8819 = 21072.3168 =21072.32

Hence NPV of the project = 21072.32

Since the project has generated a positive NPV, therefore present value of cash inflows of project is greater that present value of its cash outflows. Hence, the amount earned on the this project is greater that costs incurred on the project in present value terms. The project is generating positive shareholder value. Therefore this project should be undertaken or accepted