Gateway Communications is considering a project with an initial fixed asset cost
ID: 2817247 • Letter: G
Question
Gateway Communications is considering a project with an initial fixed asset cost of $2.5 million which will be depreciated straight-line to a zero book value over the 5-year life of the project. At the end of the project the equipment will be sold for an estimated $400,000. The project will not directly produce any sales but will reduce operating costs by $730,000 a year. The tax rate is 35 percent. The project will require $50,000 of changes in net working capital which will be recouped when the project ends. Should this project be implemented if the firm requires a 12 percent rate of return? What is the NPV?
Explanation / Answer
Annual depreciation=(Cost-Salvage value)/USeful Life
=$2.5million/5 years
=$500,000/year
Hence annual operating cash flows=Savings in operating costs*(1-tax rate)+Tax savings on Annual depreciation
=$730000(1-0.35)+0.35*500,000
which is equal to
=$649500
Cash flow as a result of sale of equipment;net of tax=$400,000(1-tax rate)
=$400,000(1-.35)=$260,000
Cash flow after year 5 as a result of release of net working capital=$50000
Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)
=$649500/1.12+$649500/1.12^2+.............+$649500/1.12^5+260000/1.12^5+50000/1.12^5
=$649500[1/1.12+1/1.12^2+.............+1/1.12^5]+(260000/1.12^5)+(50000/1.12^5)
=($649500*3.604776202)+($260,000*0.567426855)+($50000*0.567426855)
which is equal to
=$2,517,204.468(Approx)
Present value of outflows=$2.5 million+$50000
=$2,550,000
NPV=Present value of inflows-Present value of outflows
=$2,517,204.468-$2,550,000
=($32795.53)(Approx).(Negative).
Hence since NPV is negative;project should not be implemented.
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