Gaston Company is considering a capital budgeting project that would require a $

Question

Gaston Company is considering a capital budgeting project that would require a $2,900,000 investment in equipment with a useful life of five years and no salvage value. The company’s tax rate is 30% and its after-tax cost of capital is 13%. It uses the straight-line depreciation method for financial reporting and tax purposes. The project would provide net operating income each year for five years as follows:

Gaston Company is considering a capital budgeting project that would require a $2,900,000 investment in equipment with a useful life of five years and no salvage value. The company’s tax rate is 30% and its after-tax cost of capital is 13%. It uses the straight-line depreciation method for financial reporting and tax purposes. The project would provide net operating income each year for five years as follows:

Explanation / Answer

Net present value is the difference between the present value of cash inflows and cash outflows. The formula for calculating NPV is given below:

NPV = -Initial Investment + Annual Cash Inflow*PVIFA(Cost of Capital,Years)

where Annual Cash Inflow = Net Operating Income + Depreciation

and PVIFA is Present Value Interest Factor for An Annuity (which can be derived with the of Present Value Tables/Financial Calculator)

__________

Solution:

Using the values provided in the question, we get,

Annual Cash Inflow = 480,000 + 580,000 = $1,060,000

NPV = -2,900,000 + 1,060,000*PVIFA(13%,5 Years) = -2,900,000 + 1,060,000*3.517 = $828,020 (answer)

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