Use the following information for the problem. Year 2 4 MACRS Depreciation Allow

Question

Use the following information for the problem. Year 2 4 MACRS Depreciation Allowances for 3-year Property Class 33.33% oJ3s? 14.82%-a/482 7.41% 0.0741 Your company just bought a new distilaion unit for $130,000. Such equipment has a 3-year MACRS classification. a) Wh at is the book value of the distillation unit at the end of year 3? Use the $130,000 cost of the unit and the MACRS table above to find the book value. M b) If the distillation unit will be sold in 3 years for $50,000, what is the after-tax cash flow (i.e, after-tax salvage value) from the sale? The tax rate is 35 percent. 3 c) The distillation unit is used in a project that has a three-year life. The project is expected to generate the following operating cash flows. The initial investment required for the project consists only of the cost of purchasing the distillation unit. It does not require net workin capital. It has no other cash flows besides the operating cash flows and the cash flow from sellin the equipment at the end of the project in (b). If the required rate of return on the project is percent, what is the net present value of the project? Should it be accepted? Why? Year Operating cash flow (OCF) $50,000 60,000 80,000

Explanation / Answer

Part a)

The book value of distillation unit at the end of Year 3 is calculated as below:

Book Value of Distillation Unit at End of Year 3 = Cost of Unit*(1-MACRS Depreciation Rate for Year 1-MACRS Depreciation Rate for Year 2-MACRS Depreciation Rate for Year 3)

Substituting values in the above formula, we get,

Book Value of Distillation Unit at End of Year 3 = 130,000*(1-33.33%-44.44%-14.82%) = $9,633

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Part 2)

The after-tax cash flow is determined as below:

Gain on Sale of Unit = Sales Value - Book Value = 50,000 - 9,633 = $40,367

Tax on Gain = Gain on Sale of Unit*Tax Rate = 40,367*35% = $14,128.45

After-Tax Cash Flow = Sale Value - Tax on Gain = 50,000 - 14,128.45 = $35,871.55

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Part 3)

NPV is the difference between the present value of cash inflows and cash outflows. It can be calculated with the use of following formula:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Required Rate of Return)^1 + Cash Flow Year 2/(1+Required Rate of Return)^2 + Cash Flow Year 3/(1+Required Rate of Return)^3

Susbtituting values in the above formula, we get,

NPV = -130,000 + 50,000/(1+12%)^1 + 60,000/(1+12%)^2 + (80,000 + 35,871.55)/(1+12%)^3 = $44,949.57

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