Gateway Communications is considering a project with an initial fixed asset cost

Question

Gateway Communications is considering a project with an initial fixed asset cost of $2.46 million which will be depreciated straight-line to a zero book value over the 10-year life of the project. At the end of the project the equipment will be sold for an estimated $300,000. The project will not directly produce any sales but will reduce operating costs by $725,000 a year. The tax rate is 35 percent. The project will require $45,000 of inventory which will be recouped when the project ends. Should this project be implemented if the firm requires a 14 percent rate of return? Why or why not?

Explanation / Answer

Hi,

Please find the detailed answer as follows:

Initial Investment = -2460000 - 45000 (inventory costs)

Annual Cash Inflow = (Annual Savings - Depreciation)*(1-Tax Rate) + Depreciation = (725000 - 2460000/10)*(1-.35) + 2460000/10 = 557350

Terminal Year Cash Inflow = Annual Cash Inflow + Inventory Cost Recovery + Sales Value*(1-Tax Rate) = 557350 + 45000 + 300000*(1-.35) = 797350

NPV = -2505000 + 557350/(1+.14)^1 + 557350/(1+.14)^2 + 557350/(1+.14)^3 + 557350/(1+.14)^4 + 557350/(1+.14)^5 + 557350/(1+.14)^6 + 557350/(1+.14)^7 + 557350/(1+.14)^8 + 557350/(1+.14)^9 + 797350/(1+.14)^10 = 466940.57

The project should be Implemented as it offers a Positive NPV

Thanks.

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