Case Study

Part B

Question 1

What is the project’s net present value (NPV)? Explain the economic rationale behind the NPV. Could the NPV of this particular project be different for SRC than for one of Wang’s other potential customers?

Answer:

Table 1.1: Depreciation Table

Year | Depreciation |

1 | $85,000 × 20% = $17,000 |

2 | $85,000 × 32% = $27,200 |

3 | $85,000× 19% = $16,150 |

4 | $85,000 × 12% = $10,200 |

5 | $85,000 × 11% = $9,350 |

6 | $85,000 × 6% = $5,100 |

Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |

Cost of new system | $80,000 | - | - | - | - | - | - | - | - |

Installation cost | -5,000 | - | - | - | - | - | - | - | - |

Tax Saving | - | $25,000 | $25,000 | $25,000 | $25,000 | $25,000 | $25,000 | $25,000 | $25,000 |

Depreciation on system | 0 | -17,000 | -27,200 | -16,150 | -10,200 | -9,350 | -5,100 | 0 | 0 |

Profit before tax | 85,000 | 8,000 | -2,200 | 8,850 | 14,800 | 15,650 | 19,900 | 25,000 | 25,000 |

Less: tax (40%) | 0 | -3,200 | -880 | -3,540 | -5,920 | -6,260 | -7,960 | -10,000 | -10,000 |

Profit after tax | 85,000 | 4,800 | -1,320 | 5,310 | 8,880 | 9,390 | 11,940 | 15,000 | 15,000 |

Add: depreciation | 0 | 17,000 | 27,200 | 16,150 | 10,200 | 9,350 | 5,100 | 0 | 0 |

After Tax Cash Flow | $85,000 | $21,800 | $25,880 | $21,460 | $19,080 | $18,740 | $17,040 | $15,000 | $15,000 |

  |   |   |   |   |   |   |   |   |   |

Table 1.2: Cah Flow for SRC:

Based on the table 1.2:

Net Present Value (NPV)

= 21800 (1.1)-1 + 25880 (1.1)-2+21460(1.1)-3+19080(1.1)-4+18740(1.1)-5+17040(1.1)-6+ 15000(1.1)-7 + 15000(1.1)-8 – 85000

= 19818 + 21388 + 16123 + 13032 + 11636 + 9619 + 7697 + 6998 – 85000

= $ 21311

Hence, the NPV for the project is $21311.

Economic rationale of using NPV

There are a number of advantages of using NPV to evaluate capital investment projects. According to Megginson (et al 2010), “the NPV rule focuses on cash flow.” Besides that, it can make suitable adjustments for the time value of money. Therefore,...