Your firm is considering a new product development. An outlay of $110,000 is req

Question

Your firm is considering a new product development. An outlay of $110,000 is required for equipment, and additional net working capital of $5,000 is required. Implementing the project will generate a time zero investment tax credit benefit of $3,000 for the firm (i.e. at the beginning of the project). The project is expected to have a 4 year life, and the equipment will be depreciated on a straight line basis to a $10,000 book value. Producing the new product will reduce current manufacturing expenses (costs) by $20,000 annually and increase earnings (revenue) before depreciation and taxes by $23,000 annually. Stanton’s marginal tax rate is 40 percent. Stanton expects the equipment will have a market salvage value of $15,000 at the end of 4 years.

Explanation / Answer

1. Total cost at time zero = Cost of the equipment + Additional working capital - Tax credit benefit

= 110,000 + 5,000 - 3,000 = $112,000

2. Calculation of depreciation:

Depreciation = Cost - Salvage / Life

Depreciation per year = 110,000 - 10,000 / 4 = $25,000

3. Annual Cash increment = 20,000 saving in cost + 23,000 increase in earnings = $43,000

Less: Depreciation $25,000 = $18,000

Less: Tax = 18,000 x 40% = $7,200

After tax cash inflow = 18,000 - 7,200 + 25,000 = $35,800

Present Value of 4 Year annuity at 9% of $35,800 = $115,981.97

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