Dog Up! Franks is looking at a new sausage system with an installed cost of $455

Question

Dog Up! Franks is looking at a new sausage system with an installed cost of $455,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $65,000. The sausage system will save the firm $235,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $24,000. If the tax rate is 34 percent and the discount rate is 10 percent, what is the NPV of this project?

Explanation / Answer

Working notes:

(1) Annual depreciation = $455,000 / 5 = $91,000

(2) After-tax benefits (per year) = $235,000 x (1 - 0.34) = $235,000 x 0.66 = $155,100 [Years 1 to 4]

(3) In year 5,

Pre-tax benefit = $(235,000 + 65,000 [Salvage**]) = $300,000

After-tax benefit = $300,000 x (1 - 0.34) = $300,000 x 0.66 = $198,000

**Assuming salvage value is taxable.

(3) First cost = $(455,000 + 24,000) = $479,000

(4) After-tax cash flow (ATCF) [Years 1 to 4] = After-tax benefit + Depreciation

(5) After-tax cash flow, Year 0 = - First cost

(6) NPV = Sum of all discounted ATCF

Year First Cost After-tax benefit Depreciation ATCF Discount factor @10% Discounted ATCF (A) (B) (C) (D)=(B)+(C)-(A) (E) (D) x (E) 0 4,79,000 -4,79,000 1.0000 -4,79,000 1 1,55,100 91,000 2,46,100 0.9091 2,23,727 2 1,55,100 91,000 2,46,100 0.8264 2,03,388 3 1,55,100 91,000 2,46,100 0.7513 1,84,899 4 1,55,100 91,000 2,46,100 0.6830 1,68,090 5 1,98,000 91,000 2,89,000 0.6209 1,79,446 NPV ($) = 4,80,550

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