Fairfax Paint is evaluating a 2-year project that would involve buying equipment

Question

Fairfax Paint is evaluating a 2-year project that would involve buying equipment for 230,000 dollars that would be depreciated to 40,000 dollars over 2 years using straight-line depreciation. Cash flows from capital spending would be 0 dollars in year 1 and 47,000 dollars in year 2. To finance the project, Fairfax Paint would borrow 230,000 dollars. The firm would receive 230,000 dollars from the bank today and would pay the bank $0 in 1 year and 236,900 dollars in 2 years (consisting of an interest payment of 6,900 dollars and a principal payment of 230,000 dollars). Relevant annual revenues are expected to be 219,000 dollars in year 1 and 167,000 dollars in year 2. Relevant annual costs are expected to be 47,000 dollars in year 1 and 73,000 dollars in year 2. The tax rate is 50 percent. The cost of capital is 9.54 percent. What is the net present value of the project?

Explanation / Answer

Answer:

Note: Net income in negative in 2nd year. Hence no tax is payable in 2nd year.

(In $) Year 1 Year 2 Revenue 219,000              167,000 Less: Annual Costs -47,000 -73,000 Less: Depreciation(230,000-40,000)/2 -95,000 -95,000 Add:Income from sale of equipment (47,000-40,000) 7,000 Less: Interest on bank loan -6,900 Net profit before tax 77,000 -900 Less: Tax @50% of net income -38,500 0 Net profit after tax 38,500 -900 Add: Depreciation 95,000 95,000 Add: Remaining cash inflow from sale of equipment(47,000 - 7,000) 40,000 Less: Payment of bank loan -230,000 Net cash flow 133,500 -95,900 P.V. factor @ 9.54% 0.913 0.833 Present value of net cash flows (Net cash flow*factor)                121,873              (79,923) Net Present value (Total of 2 years)                  41,950

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