Note: In this problem you are given more information than you might need. Petrol

Question

Note: In this problem you are given more information than you might need. Petroleum Exploration and Refining Services is trying to decide the After Tax merits of two competing investments. The choices are A fleet of general purpose heavy trucks. Initial Investment 400,000 Salvage Value after 10 years is 40,000. Before Tax Revenue above Expenses is 90,000/yr. For each of the 10 years. Petroleum Production Equipment Initial Cost 500,000. Salvage Value after 20 years is 20,000. Before Tax Revenue over Expenses are 120,000/yr. over the entire 20 year period. The company mandates that you compare the two choices for the first 6 years and decide on the Present Worth over the first 6 years. Use MACRS (government mandated) depreciation. Income Tax Rate is 40% Interest rate I = 12%, Use PW of the After Tax Cash Flow as the criterion, but show for each year the depreciation, Taxable Income, Taxes, and After Tax Cash Flow.

Explanation / Answer

In this problem, Petroleum exploration and refining service is considering two different investment proposals. First one has 10 years life and the second one has 20 years life. You have to calculate present worth of first six years of the two projects. Use MACRS depreciation on the basis of 5 years. Note that project has not mentioned the period of macrs. But since you have to compute present worth for first six years, use 5 years MACRS rate.

First consider the MACRS depreciation rate. It is twice the rate under straight line. In straight line method, depreciation of 5 years period is 100/5=20% per year. This methoid required it to double. So it is 40%. Apply it on buy price of the machine ignoring scrap value. However first year will start from middle of the year. So 6 months rate is applied on first year. Hence for 5 years MACRS, first years rate is 20%.

In second year 80% of the cost price is left for recevery. So apply 40% on it. Thus second years MACRS is 0.8x0.4=32%. Proceed in this manner till 6 years. In 6th year half year depreciation will be chared. So MACRS are 20%, 32%, 19.2%, 11.52%, 11.52% and 5.76%.

Calculation procedures are explained below:

1. First consider yearl revenues.

2. Deduct depreciation from yearly revenues using MACRS 5 years rate to get taxable income

3. Ascertain tax at 40%. Deduct it to get revenue after tax

4. Add depreciation with after tax revenue to get cash flows.

5. Now ascertain discounting factor of doller at 12% interest rate.

6. multiply 4 and 5 to get present value of cash flow.

7. Add then to get total 6 years gros present worth

8. Finally deduct initial cash outflow to get net present worth for 6 years.

Caculations are shown below:

All required figures of the problem are stated in the above table. Both hae negative present worh as you have considered only first six years of life.

Present worth of general purpose heavy truck Year 0 1 2 3 4 5 6 1. Initial investment 400,000 2. Revenue per year 90,000 90,000 90,000 90,000 90,000 90,000 3. MACRS 5 year Depreciation rates 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% 4. Depreciation [2*3] 18000 28800 17280 10368 10368 5184 5. Taxable income [2-4] 72,000 61,200 72,720 79,632 79,632 84,816 6. Tax at 40% 28800 24480 29088 31852.8 31852.8 33926.4 7. Income after depreciatioin & tax[5-6] 43,200 36,720 43,632 47,779 47,779 50,890 8. Add: Depreciation 18000 28800 17280 10368 10368 5184 9. After tax cash flow [7+8] 61,200 65,520 60,912 58,147 58,147 56,074 10. Discounting factor of a $ at 12% 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631 11. Present value [9*10] 54642.86 52232.14 43355.96 36953.6 32994.28 28408.63 12. Total present value of cash inflows 248587.5 13. Initial investment 400,000 14. Net present worth [12-13] -151,413 Present worth of petroleum product equipment Year 0 1 2 3 4 5 6 1. Initial investment 500,000 2. Revenue per year 120,000 120,000 120,000 120,000 120,000 120,000 3. MACRS 7 year Depreciation rates 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% 4. Depreciation [2*3] 24000 38400 23040 13824 13824 6912 5. Taxable income [2-4] 96,000 81,600 96,960 106,176 106,176 113,088 6. Tax at 40% 38400 32640 38784 42470.4 42470.4 45235.2 7. Income after depreciatioin & tax[5-6] 57,600 48,960 58,176 63,706 63,706 67,853 8. Add: Depreciation 24000 38400 23040 13824 13824 6912 9. After tax cash flow [7+8] 81,600 87,360 81,216 77,530 77,530 74,765 10. Discounting factor of a $ at 12% 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631 11. Present value [9*10] 72857.14 69642.86 57807.94 49271.46 43992.38 37878.17 12. Total present value of cash inflows 331450 13. Initial investment 500,000 14. Net present worth [12-13] -168,550

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