2) (30 pts) Your company has just signed a three-year nonrenewable contract with

Question

2) (30 pts) Your company has just signed a three-year nonrenewable contract with the city of New Orleans for earthmoving work. You are investigating the purchase of heavy construction equipment for this job. The equipment cost $250,000 and qualifies for GDS 5 year depreciation. At the end of the three-year contract you are expected to be able to sell the equipment for $20,000. If the projected marginal benefits of the project is $90,000 per year is the contract worthwhile of undertaking? You are paying three different taxes to Local, State and Federal government, respectively, at 2%, 4% and 25%. Also, your company average rate of return on its projects in an environment that has 4% inflation is 10% per year

Explanation / Answer

Given:

The contract is of 3years and non-renewal.

Equipment cost = $250,000 and qualifies for depriciation 5years.

Future price = $20,000

Project Marginal Benefit = $90000 per year

Therefore, Total benefit from the project = $90000*3

or, Total benefit from the project = $270000

This is more than the equipment cost. So the contract is worth-taking. As there will be a profit of ($270000-$250000=) $20,000.

When taxes are applied then

Each year's total return = $90000+$90000*(10%-4%) =$90000+ $90000* 6% = $95400

Each years's local tax = $90000*2% =$1800

Each years's local tax = $90000*4% =$3600

Each years's local tax = $90000*25% =$22500

Thus, total tax to be paid = $(1800+3600+22500) =$27900

Net profit each year = $(95400-27900) = $67500

Hence, it is worth-taking the contract.

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