FedEx can purchase a large-volume copier for $18,000 and depreciates it by strai

Question

FedEx can purchase a large-volume copier for $18,000 and depreciates it by straight-line depreciation. The net benefits from the copier, before deducting depreciation, are $1000 at the end of the first year and increasing $1000 per year after that (second year equals $2000, third year equals $3000, etc.), until disposal at the end of 10 years. During the 10-year period, there will be an inflation rate of 5%. FedEx has a 35% combined incremental tax rate. If FedEx requires a real 9% after-tax rate of return on its investments, should the firm purchase the copier? Why?

Explanation / Answer

Working notes:

(1) Annual depreciation (D) = Cost / Useful life = $18,000 / 10 = $1,800

(2) Earning before tax (EBT) = Net benefit - Depreciation = Net benefit - $1,800

(3) Earning after tax (EAT) = EBT x (1 - tax rate) = EBT x (1 - 0.35) = EBT x 0.65

(4) Cash flow after tax (CFAT) = EAT + Depreciation (being non-cash expense, it is added back)

NOTE: CFAT for year 0 = Cost of copier = - $18,000

(5) Nominal rate of return = Real rate + Inflation rate = 9% + 5% = 14%

(6) CFAT is discounted at nominal rate of return.

Therefore,

Since NPV is positive, the copier should be purchased.

(A) CASH FLOW (ALL VALUES IN $) Year D Net benefit EBT EAT CFAT (A) (B) (C)=(B)-(A) (D)=(C)x0.65 (D)+(A) 0 -18,000 1 1,800 1,000 -800 -520 1,280 2 1,800 2,000 200 130 1,930 3 1,800 3,000 1,200 780 2,580 4 1,800 4,000 2,200 1430 3,230 5 1,800 5,000 3,200 2080 3,880 6 1,800 6,000 4,200 2730 4,530 7 1,800 7,000 5,200 3380 5,180 8 1,800 8,000 6,200 4030 5,830 9 1,800 9,000 7,200 4680 6,480 10 1,800 10,000 8,200 5330 7,130

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