W5 Project

FI 515 Week 5 Project Solution

11-7 a. The net cost is $89,000:

Price ($70,000)

Modification (15,000)

Change in NWC (4,000)

($89,000)

b. The operating cash flows follow:

Year 1 Year 2 Year 3

After-tax savings $15,000 $15,000 $15,000

Depreciation shield 11,220 15,300 5,100

Net cash flow $26,220 $30,300 $20,100

Notes:

1. The after-tax cost savings is $25,000(1 – T) = $25,000(0.6)

= $15,000.

2. The depreciation expense in each year is the depreciable basis, $85,000, times the MACRS allowance percentage of 0.33, 0.45, and 0.15 for Years 1, 2 and 3, respectively. Depreciation expense in Years 1, 2, and 3 is $28,050, $38,250, and $12,750. The depreciation shield is calculated as the tax rate (40%) times the depreciation expense in each year.

c. The additional end-of-project cash flow is $24,380:

Salvage value $30,000

Tax on SV* (9,620)

Return of NWC 4,000

$24,380

*Tax on SV = ($30,000 - $5,950)(0.4) = $9,620.

Note that the remaining BV in Year 4 = $85,000(0.07) = $5,950.

d. The project has an NPV of -$6,705. Thus, it should not be accepted.

Year Net Cash Flow

0 ($89,000)

1 26,220

2 30,300

3 44,480

With a financial calculator, input the following: CF0 = -89000, CF1 = 26220, CF2 = 30300, CF3 = 44480, and I/YR = 10 to solve for NPV = -$6,703.83.