Calculate the net present value-investment proposal, Financial Management

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As you checked the Answer Key to Question 6 in the Mastery Check from this lesson you may have noted that each year's net cash flows are calculated by adding depreciation back to net earnings:

Question 6 Jayhawk Company has a proposed contract with the Comprehensive Systems of Kansas. The initial investment in land and equipment will be $120,000. Of this amount, $70,000 is subject to five-year MACRS depreciation. The balance is in non-depreciable property. The contract covers six years. At the end of six years, the non-depreciable assets will be sold for $50,000. The depreciated assets will have zero resale value.

The contract will require an investment of $55,000 in working capital at the beginning of the first year, and, of this amount, $25,000 will be returned to the Jayhawk Technology Company after six years.

The investment will produce $50,000 in income before depreciation and taxes for each of the six years. The corporation is in a 40 percent tax bracket and has a 10 percent cost of capital.

Using a piece of paper or a computer spread sheet, determine whether or not the investment should be undertaken. Use the net present value method.

Answer

Problem 6

 

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

EBIDT

 

50,000

50,000

50,000

50,000

50,000

50,000

Depreciation

 

14,000

22,400

13,440

8,050

8,050

4,060

Earnings before taxes

 

36,000

27,600

36,560

41,950

41,950

45,940

Taxes

 

14,400

11,040

14,624

16,780

16,780

18,376

Earnings after taxes

 

21,600

16,560

21,936

25,170

25,170

27,564

Depreciation

 

14,000

22,400

13,440

8,050

8,050

4,060

Cash flow

 

35,600

38,960

35,376

33,220

33,220

31,624

Investment

-120,000

 

 

 

 

 

50,000

Net work capital

-55,000

 

 

 

 

 

25,000

 

-175,000

 

 

 

 

 

106,624

NPV = 19,564 @ 10% cost of capital (The answer is $19,643 with a financial calculator.)

On the other hand, the problem in Part 1 of this assignment specifies a series of steps that leads you through the same approach as that used in the answer key for Question 8 in the Mastery Check of this lesson:

Question 8 The Acme Corporation is considering the purchase of an additional lathe to handle periodic overload conditions in the shop. By reducing overtime premiums, purchase of this lathe will result in cash savings of $20,000 per year before taxes. The new lathe would cost $50,000 and would be depreciated using 5 year MACRS. However, it is anticipated that it would be sold at the end of 5 years for an estimated $15,000.

Using a piece of paper or a computer spreadsheet, calculate the after-tax cash flows for this investment proposal using the method described in the discussion material for this lesson. (That is, calculate the after-tax cash flows as if there were no non-cash expenses.) Then adjust these after-tax cash flows for the tax credits resulting from the non-cash tax shields. Calculate the net present value of this investment proposal using a 15% discount rate. Acme's marginal tax rate is 40%.

Answer

Problem 8

 

Year 0

Year 1

Year 2

Year3

Year 4

Year5

EBIDT

 

20,000

20,000

20,000

20,000

20,000

(1) After tax @ 40% tax rate

 

12,000

12,000

12,000

12,000

12,000

Depreciation

 

10,000

16,000

9,600

5,750

5,750

(2) Depreciation tax credit

 

4,000

6,400

3,840

2,300

2,300

Yearly cash flow (1) + (2)

 

16,000

18,400

15,840

14,300

14,300

Investment/salvage

-50,000

 

 

 

 

10,160

Total cash flow

-50,000

16,000

18,400

15,840

14,300

24,460

NPV = $8,589.34 @ 15% cost of capital. (Answer is $8,578.16 with a financial calculator)

Depreciation and Book Value

 

 

 

 

 

 

Year

0

1

2

3

4

5

Depreciation percent

 

0.200

0.320

0.192

0.115

0.115

Depreciation

 

10000

16000

9600

5750

5750

Remaining book value

 

40000

24000

14400

8650

2900

 

 

 

 

 

 

 

Sale price

 

 

 

 

 

15000

Book value

 

 

 

 

 

2900

Taxable profit on sale

 

 

 

 

 

12100

Tax on profit on sale

 

 

 

 

 

4840

Net proceeds from sale

 

 

 

 

 

10160

Rework and submit Question 6 using the same approach to calculate each year's after-tax cash flows as is used to solve Question 8.

That is, calculate the after-tax cash flows as if there were no non-cash expenses. Then, adjust these after-tax cash flows for the tax credits resulting from the non-cash tax shields. (This is the method the problem in Part 1 leads you through as you follow the specified steps a through o for solving that problem).

Carefully examine the solution to Problem 6, but solve it using this alternative method. Be sure to check your answer. If you get a different answer than the Answer Key gives for Problem 6, you have made an error.


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