Dog Up! Franks is looking at a new sausage system with an installed cost of $397

Question

Dog Up! Franks is looking at a new sausage system with an installed cost of $397,800. This cost will be depreciated straight-line to zero over the project's 7-year life, at the end of which the sausage system can be scrapped for $61,200. The sausage system will save the firm $122,400 per year in pretax operating costs, and the system requires an initial investment in net working capital of $28,560. All of the net working capital will be recovered at the end of the project. The tax rate is 33 percent and the discount rate is 9 percent. What is the net present value of this project?

Explanation / Answer

Pre tax savings = $122,400. savings after tax = 122,400*(1-tax rate) = 122,400*(1-33%) = $82,008

Depreciation per year (assuming no scrap value) = installed cost/life = 397,800/7 = 56,828.57

Depreciation tax shield = depreciation * tax rate = 56,828.57*33% = $18,753.43

Operating cash flow = savings after tax+depreciation tax shield

= $82,008+$18,753.43 = $100,761.43

Salvage value = 61,200. after tax proceeds = salvage value*(1-tax rate) = 61,200*(1-33%) = $41,004

Formulas used in the below table: (i) discount factor = 1+discount rate (ii) PV = Cash flow/(discount factor)^time (iii) NPV = sum of all PVs

Thus the NPV = $118,821.41

Year Cash flow Description Discount factor PV 0 -397,800.00 installed cost 1.09 -397,800.00 0 -28,560.00 working capital investment -28,560.00 1 100,761.43 operating cash flow 92,441.68 2 100,761.43 operating cash flow 84,808.88 3 100,761.43 operating cash flow 77,806.31 4 100,761.43 operating cash flow 71,381.94 5 100,761.43 operating cash flow 65,488.01 6 100,761.43 operating cash flow 60,080.75 7 100,761.43 operating cash flow 55,119.95 7 41,004.00 After tax sale proceed of system 22,430.59 7 28,560.00 recovery of working capital investment 15,623.30 NPV 118,821.41

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