ABC is considering the purchase of new equipment for $103,000. The equipment is

Question

ABC is considering the purchase of new equipment for $103,000. The equipment is to be depreciated using the 5 year MACRS schedule, which is shown below. ABC plans to sell the equipment at the end of four years and projects that the equipment's market value at that time will be $27,000. The equipment is expected to generate an operating profit before taxes and depreciation of $27,000. Net working capital of $12,000 will be needed when the equipment is purchased, but will be recovered after the equipment is sold. The company's tax rate is 40 percent and its cost of capital for this project is 14 percent. What is the net present value of this project? MACRS Schedules For Yearly Depreciation Year 3 Year 5 Year 10 Year 1 33% 20% 10% 2 45% 32% 18% 3 15% 19% 14% 4 7% 12% 12% 5 11% 9% 6 6% 7% 7 7% 8 7% 9 7% 10 6% 11 3%

Explanation / Answer

Calculation of net present value of project Year 0 1 2 3 4 NPV Cost of new equipment -$103,000 Investment in net working capital -$12,000 Recovery of net working capital $12,000 Operating cash flows $24,440 $29,384 $24,028 $21,144 Salvage value of equipment $23,204 Net Cash flow -$115,000 $24,440 $29,384 $24,028 $56,348 Discount factor @ 14%             1.00000              0.87719       0.76947         0.67497           0.59208 Present Values -$115,000.00 $21,438.60 $22,610.03 $16,218.22 $33,362.54 -$21,370.61 Net present value of project = -$21,370.61 Working Calculation of depreciation on equipment using 5 year MACRS schedule Year Cost of equipment Depreciation rate Depreciation 1 $103,000 20% $20,600 2 $103,000 32% $32,960 3 $103,000 19% $19,570 4 $103,000 12% $12,360 5 $103,000 11% $11,330 Calculation of operating cash flows from the project Year                          1 2 3 4 Operating profit before taxes and depreciation $27,000 $27,000 $27,000 $27,000 Less : Depreciation $20,600 $32,960 $19,570 $12,360 Profit before taxes $6,400 -$5,960 $7,430 $14,640 Less : Taxes $2,560 -$2,384 $2,972 $5,856 Profit after taxes $3,840 -$3,576 $4,458 $8,784 Add : Depreciation $20,600 $32,960 $19,570 $12,360 Operating Cash flow $24,440 $29,384 $24,028 $21,144 Calculation of after tax salvage value of equipment at the end of 4th Year Market value of Equipment $27,000 Less : Book value of equipment $17,510 Gain on sale $9,490 Tax on Gain @ 40% $3,796 After tax salvage value (market value - taxes) $23,204

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