## 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.

 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%.

 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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