You bought a survey device at $750,000 at beginning of year 1. You expect to use

Question

You bought a survey device at $750,000 at beginning of year 1. You expect to use it to generate an annual revenue of $350,000 for year 1 and increase at 4% per year. The operating expenses will be $ 120,000 for year 1 and increase at 3% per year. At end of year 3, you can sell the device for $300,000 and close the business. Assuming you will have an income tax rate of 30% every year and a capital gain tax rate of 15% at year 3 and you will take depreciation charge every year based on the MACRS schedule as follows:

Year 1 20%

Year 2 32%

Year 3 19.2%

Also clearly show the calculations of each year’s Depreciation Charges, Cash Flow After Tax at Year 3 for selling of the device and calculations of the present value and IRR, separately.

Part 2

Assuming you will obtain a bank loan of $450,000 at an interest rate of 6% per year. The loan requires interest payment only at end of each year and the loan principle is due at end of the 3rd year (like a bond arrangement). Everything else stays the same as Part 1. Re-calculate everything as you did in Part 1.

Based on the result of Part 2, make your recommendation as which way to go, Part 1 or Part 2, and explain how financial leverage works?

Explanation / Answer

Cost of Device = $750,000 Year Rate as MACRS Depreciation 1 20% $150,000 2 32% $240,000 3 19.20% $144,000 Salvage Value = $300,000 at the end of year 3 Revenue per year = $350,000 Operating expenses per year= $120,000 Tax rate = 30% After tax slavage value (at 15% capital gain tax) = $255,000 Year 0 1 2 3 Revenue $350,000 $364,000 $378,560 operating expense $120,000 $123,600 $127,308 EBITDA $230,000 $240,400 $251,252 Depreciation $150,000 $240,000 $144,000 Taxable income $80,000 $400 $107,252 Tax(30%) $24,000 $120 $32,176 Net Income $56,000 $280 $75,076 After TaxSalvage value $255,000 CFAT $206,000 $240,280 $474,076 Initial Investment ($750,000) Cash Flows ($750,000) $206,000 $240,280 $474,076 So Net present value at MARR of 12% = ($37,083.47) And IRR = 9.47% Part-2 Bank loan = $450,000 at 6% per annum Year 0 1 2 3 Revenue $350,000 $364,000 $378,560 operating expense $120,000 $123,600 $127,308 EBITDA $230,000 $240,400 $251,252 Depreciation $150,000 $240,000 $144,000 Interest $27,000 $27,000 $27,000 Taxable income $53,000 ($26,600) $80,252 Tax(30%) $15,900 $0 $24,076 Net Income $37,100 ($26,600) $56,176 After TaxSalvage value $255,000 CFAT $187,100 $213,400 $455,176 Initial Investment ($750,000) Cash Flows ($750,000) $187,100 $213,400 $455,176 So Net present value at MARR of 12% = ($88,839.68) And IRR = 5.91%

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