11-B3 Taxes, Straight-Line Depreciation, and NPV The president of Genomics, Inc.

Question

11-B3 Taxes, Straight-Line Depreciation, and NPV The president of Genomics, Inc., a biotechnology company, is considering the purchase of some equipment used for research and development. The cost is S400.000, the economic life and the recov ery period are both five years, and there is no terminal disposal value. Annual pretax cash inflows from operations would increase by $140,000, giving a total five-year pretax savings of $700,000. The income tax rate is 40%, and the required after-tax rate ofreturn is 14%. 1. Compute the net present value, assuming straight-line depreciation of $80,000 yearly for tax pur- poses. Should Genomics acquire the equipment?

Explanation / Answer

Annul Cash Inflows Annual pretax cash savings 140,000 Less: Annual depreciation (400,000 /5) 80000 Net INCome before tax 60000 Less: Tax @ 40% 24000 Net income after tax 36000 Add: Depreciation 80000 Annual cash inflows 116000 Present value Annuity factor for 5 yrs at 14% 3.433 Present value of cash inflows ($116,000*3.433) 398228 Less: Initial investment 400,000 Net present Value -1,772 Hence, the project shall not be accepted

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