You have been asked by the president of your company to evaluate the proposed ac

Question

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck with the following additional facts:

The trucks basic price is $50,000 and it will cost another $10,000 to modify the truck for special use by your firm.

The truck falls into the MARCS five year class life (applicable annual percentages are 20%, 32%, 19%, 12%, 11%, and 6%) and the truck will be sold after two years for $40,000.

Use of the truck requires an increase in net working capital by your company of $2,000 (spare parts and inventory)

The truck will have no effect on your company's revenues but is expected to save the firm $20,000 per year in before tax operating costs, mainly labor costs.

Your firms marginal income tax rate is 40%

Your firms capital structure is 50% debt and 50% equity. The firm calculates its WACC to be 9% using the following inputs: before tax cost of debt of 10%, cost of quity of 12%, an expected market return of 12%, a risk free rate of 4.0%, and a firm beta of 1.0.

1.  What is the net investment in the truck project (that is what is the Year 0 net cash flow)?

2.  What are the operating cash flows in Year 1 and Year 2 resulting from the project?

3.  What is the NPV of this project?

4.  Should the project be pursued? (Yes or No and state a reason or reasons)

Explanation / Answer

Depreciable basis = $60,000.

MACRS Depreciable

Year Percent Basis Depreciation

1 0.33 $60,000 $19,800

2 0.45 60,000 27,000

3 0.15 60,000 9,000

4 0.07 60,000 4,200

Operating cash flows:

Yea r 1 2 3

1) Before-tax cost reduction $20,000 $20,000 $20,000

2) After-tax cost reduction

(line 1 x 0.6) 12,000 12,000 12,000

3) Depreciation 19,800 27,000 9,000

4) Tax savings from deprec.

(line 3 x 0.4) 7,920 10,800 3,600

5) Net operating CFs $19,920 $22,800 $15,600

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