Question

ATT is considering a project. The project requires to purchase an equipment with a cost of $1.55 million. The equipment will be depreciated straight-line to a zero book value over the 9-year life of the project. At the end of the project it will be sold for a market value of $240,000. The project will not change sales but will reduce operating costs by $399,000 per year. The project also requires an initial investment of $52,000 in net working capital, which will be recouped when the project ends. The tax rate is 34 percent.

(1) What is the cash flow of the project in year 0 (or at the beginning of the project)?

(2) What is the cash flow of the project in each year from year1 to year 8?

(3) What is the cash flow of the project in year 9 (or the ending year)? [hint: there are 3 cash flow items, for example after-tax salvage value]

(4) What is the project's NPV if the required return is 11.5 percent? [hint: the answer for NPV value is one of the following choices:] A. $215,433 B. $276,945 C. $268,011 D. $225,225 E. $257,703

Answer 1

Initial Investment
Cost of machine	1550000
Additional Working Capital Required	52000
Total Initial Cash Flow	1602000

Intermediate Cash Flow
Reduction in Operating Cost	399000
(-)Depreciation (1550000/9)	172222.22
Saving Before Tax	226777.78
(-)Tax@34%	77104.44
Saving After Tax	149673.33
(+)Depreciation	172222.22
CFAT	321895.56

Terminal Cash Flow
Sale of Scrap after tax(240000*(1-.34)	158400
CFAT	321895.56
Recovery of Working Capital	52000
Total Terminal CF	532295.5556

Net present value =Present value of CFAT+Present Value of Terminal Cash Flow-Initial Cash Flow

Present Value of CFAT=CFAT*PV factor of annuity for 8 years @11.5%

=321895.56*5.055636778

=1627387

PV Factor of annuity=[(1+r)^{^n}-1] / [(1+r)^{^n}*r]

=[(1+.115)^{^8}-1] / [(1+.115)^{^8}*.115]

=5.055637

PV of terminal Cash Flow= Terminal Cash Flow/(1+r)^{^n}

=532295.5556/(1.115)^{^9}

=199838.4413

Net present value =1627387+199838.4413-1602000

=225225.44 or 225225

Hence answer is (D)225225

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