You are leading a business and you are told that you can sell a new product and

Question

You are leading a business and you are told that you can sell a new product and increase the revenue of the business by $100,000/yr. The operating costs will increase by $50,000/yr and you will spend $20,000 in capital to manufacture the new product. The capital is depreciable (straight line) over the same 5 years. The tax rate is 40% and the interest rate (cost of capital) is 10%. Now answer the questions in 1-5.

1. What is the annual increase in before tax cash flow ?

2. What are the additional annual taxes the business will pay due to this investment ?

3. What is the NPV of the investment ?

4. What is the approximate undiscounted payback period (in months) ?

5. Depreciation allows you to treat a portion of a capital cost as an expense in future years of a project. It therefore improves your cash flow by decreasing your taxable income.

True                              False

Explanation / Answer

1)
depriciation per year = 20000/5 = 4000

annual increase in before tax cash flow = 100000 - 50000 -4000 = 46000

2)

annual tax = (100000-50000-4000)* 0.4 = 18400

3)

intial investment = 20000

after cash flow per year = (46000-18400) + 4000 * 0.4 = 29200

NPV = -20000 + 29200 * PVIFA(10%,5) = 90690.97

4)
payback period = 20000/29200 = 8.22 months = 8 months

5)

True

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