Question

A company buys a machine for $700,000 and depreciates it on a straight-line basis to zero over a five- year period for tax purposes. The investment would result in pre-tax cash cost savings of $190,000 per year, for five years. At the end of 5 years, it is estimated that the machine can be sold for $75,000. The gain on the sale of the machine would be taxed at the company’s marginal corporate tax rate of 20%. Based on the relevant cash flows, determine the Net Present Value, Internal Rate of Return and the Payback Period of the investment. Is the investment in the machine attractive in economic terms? You can assume that the appropriate discount rate equals 14%.

Answer 1

1)	Pretax cash cost savings	$   1,90,000
	Depreciation = 700000/5 =	$   1,40,000
	Incremental EBIT	$       50,000
	Tax at 20%	$       10,000
	Incremental NOPAT	$       40,000
	Add: Depreciation	$   1,40,000
	Incremental OCF	$   1,80,000
2)	After tax salvage value = 75000*(1-20%) =	$       60,000
3)	NPV:
	PV of OCF = 180000*(1.14^5-1)/(0.14*1.14^5) =	$   6,17,955
	PV of after tax salvage value = 60000/1.14^5 =	$       31,162
	PV of cash inflows	$   6,49,117
	Less: Initial investment	$   7,00,000
	NPV	$     -50,883
4)	IRR is that discount rate for which NPV is 0.
	It has to be found by trial and error.
	Discounting with 12%:
	NPV = -700000+180000*(1.12^5-1)/(0.12*1.12^5)+60000/1.12^5 =	$     -17,095
	Discounting with 11%:
	NPV = -700000+180000*(1.11^5-1)/(0.11*1.11^5)+60000/1.11^5 =	$             869
	IRR lies between 11% and 12%.
	By simple interpolation IRR = 11%+1%*869/(869+17095) =	11.05%
5)	Payback period = 700000/180000 =	3.89	Years