Q. Net present value evaluation of proposed investment?

WORKINGS

Fixed costs = 4·50 × 100000 = $450000 per year

Annual writing down allowance = 3000000/10 = $300000

Annual writing down allowance tax benefits = 25% × 300000 = $75000

Ten-year annuity factor at 12% = 5·650

Present value of writing down allowance tax benefits = 75000 × 5·650 = $423750

Year 4 value of year 5 after-tax cash flows in perpetuity = 660000/0·12 = $5500000

Present value of these cash flows = 5500000 × 0·636 = $3498000

From the net present value perspective the proposed investment is acceptable since the net present value (NPV) is large and positive. But a large part of the present value of benefits (63%) derives from the assumption that cash flows will continue indefinitely after Year 4. This is very improbable to occur in practice and excluding these cash flows will result in a negative net present value of approximately $1·2m. In reality the planned investment will not show a positive NPV until more than seven years have passed. Prior to rejecting the proposal steps should be taken to address some of the limitations of the analysis performed.