Summer Tyme, Inc., is considering a new 3-year expansion project that requires a

Question

Summer Tyme, Inc., is considering a new 3-year expansion project that requires an initial fixed asset investment of $3.564 million. The fixed asset will be depreciated straight-line to zero over its 3-year tax life, after which time it will have a market value of $277,200. The project requires an initial investment in net working capital of $396,000. The project is estimated to generate $3,168,000 in annual sales, with costs of $1,267,200. The tax rate is 31 percent and the required return on the project is 15 percent.

What is the NPV?

Summer Tyme, Inc., is considering a new 3-year expansion project that requires an initial fixed asset investment of $3.564 million. The fixed asset will be depreciated straight-line to zero over its 3-year tax life, after which time it will have a market value of $277,200. The project requires an initial investment in net working capital of $396,000. The project is estimated to generate $3,168,000 in annual sales, with costs of $1,267,200. The tax rate is 31 percent and the required return on the project is 15 percent.

What is the NPV?

Explanation / Answer

Annual Depreciation = $3,564,000 / 3 = $1,188,000

Annual tax savings on depreciation = $1,188,000 x 31% = $368,280

Annual Operating Cash flows (net of tax) = (Sales - Cost) x (1 - 0.31) = ($3,168,000 - $1,267,200) x (1 - 0.31) = $1,311,552

Salvage Value of Fixed Asset (net of tax) = $277,200 x (1 - 0.31) = $191,268

We take the full salvage value for tax purpose since the book value of asset would be zero as it is depreciated to zero.

Now, we compute the NPV by discounting the above cash flows -

I assumed that working capital required will not recovered at the end of the project, as it is not clear in the question. In case it is recovered, we would add its present value to the above NPV as it is a cash inflow. The NPV in that case would be -

NPV = (-)88803.57 + $396000 x PVF (15%, 3) = (-)88803.57 + $260376.43 = $171572.86

NPV Particulars Year PVF @15% Amount Present Value Annual operating Cash Flows 1 - 3 2.2832251171 $1311552 $2994568.47 Add: Tax savings on depreciation 1 - 3 2.2832251171 $368280 $840866.15 Add: Salvage Value (net of tax) 3 0.65751623242 $191268 $125761.81 Total Cash Inflows Less: Initial Investment 0 1 $3654000 $3654000 Less: additional working capital 0 1 $396000 $396000 NPV (-)88,803.57

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