Question

Thomson Media is considering some new equipment whose data are shown below. The equipment has a 3-year tax life and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down. Also, additional net operating working capital would be required, but it would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? WACC 10.0% Net investment in fixed assets (depreciable basis) $70,000 Required net operating working capital $10,000 Straight-line depreciation rate 33.333% Annual sales revenues $75,000 Annual operating costs (excl. depreciation) $30,000 Expected pre-tax salvage value $5,000 Tax rate 35.0% A. $20,762 B. $21,584 C.$23,005 D.$24,155 E.$25,363

Answer 1

Time line		0	1	2	3
Cost of new machine		-70000
Initial working capital		-10000
=Initial Investment outlay		-80000
Sales			75000	75000	75000
Profits	Sales-variable cost		45000	45000	45000
-Depreciation	Cost of equipment/no. of years		-23333.3333	-23333.33	-23333.33
=Pretax cash flows			21666.66667	21666.667	21666.667
-taxes	=(Pretax cash flows)*(1-tax)		14083.33333	14083.333	14083.333
+Depreciation			23333.33333	23333.333	23333.333
=after tax operating cash flow			37416.66667	37416.667	37416.667
reversal of working capital					10000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				3250
+Tax shield on salvage book value	=Salvage value * tax rate				0
=Terminal year after tax cash flows					13250
Total Cash flow for the period		-80000	37416.66667	37416.667	50666.667
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331
Discounted CF=	Cashflow/discount factor	-80000	34015.15152	30922.865	38066.617
NPV=	Sum of discounted CF=	23005