Litchfield Design is evaluating a 3-year project that would involve buying a new

Question

Litchfield Design is evaluating a 3-year project that would involve buying a new piece of equipment for 280,000 dollars today. The equipment would be depreciated straight-line to 30,000 dollars over 2 years. In 3 years, the equipment would be sold for an after-tax cash flow of 44,000 dollars. In each of the 3 years of the project, relevant revenues are expected to be 170,000 dollars and relevant costs are expected to be 90,000 dollars. The tax rate is 50 percent and the cost of capital for the project is 7.27 percent. What is the NPV of the project?

Explanation / Answer

Calculation of Operating Cash flows-

Earnings before depreciation (170000 - 90000)

(-) Depreciation

80000

30000

80000

30000

80000

-

Earnings before tax

(-) tax @ 50 %

50000

25000

50000

25000

80000

40000

Earnings after tax

(+) Depreciation

25000

30000

25000

30000

40000

-

Present value of cash inflow = 55000 * P.V. factor for first year @ 7.27 % + 55000 * P.V. factor for second year @ 7.27 % + 40000 * P.V. factor for third year @ 7.27 % + 44000 * P.V. factor for third year @ 7.27 %

= 55000 * 0.9322 + 55000 * 0.8690 + 40000 * 0.8101 + 44000 * 0.8101

= 167114 (approx)

NPV of project = Present value of cash inflow - Present value of cash outflow

   = 167114 - 280000

= (-) 112886

As the NPV of project is negative, thus the project should not be accepted.

Particulars Year 1 Year 2 Year 3

Earnings before depreciation (170000 - 90000)

(-) Depreciation

80000

30000

80000

30000

80000

-

Earnings before tax

(-) tax @ 50 %

50000

25000

50000

25000

80000

40000

Earnings after tax

(+) Depreciation

25000

30000

25000

30000

40000

-

Operating cash flows 55000 55000 40000

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