A corporation has an investment opportunity that will involve a time zero $110,0
ID: 2652437 • Letter: A
Question
A corporation has an investment opportunity that will involve a time zero $110,000 depreciable cost for machinery and equipment. It will be depreciated starting in year 1 with an additional machinery and equipment expenditure of $60,000 at the end of year 1. Use 7 year life modified ACRS depreciation for all equipment with the half year convention in the first year. Working capital investment of $30,000 is required at time zero. Income attributed to this investment is $200,000 in year 1 and $300,000 per year in years 2 and 3. Operating costs are estimated to be $150,000 the first year and $180,000 per year in years 2 and 3. The effective tax rate is 40%. It is estimated that the business developed by this investment could be sold at the end of year 3 for $250,000 (including equipment and working capital). What discounted cash flow rate of return would be earned by this investment opportunity? What is the NPV at the 15% DCFROR?
A) DCFROR = 39.26%; NPV @ 15% = +77,653
B) DCFROR = 37.17%; NPV @ 15% = +90,628
C) DCFROR = 39.26%; NPV @ 15% = +90,628
D) DCFROR = 37.17%; NPV @ 15% = +77,653
Explanation / Answer
Answer:
Calculation of discounted cash flow rate of return
Year 0
Year 1
Year 2
Year 3
Initial Invetsment
-110000
Additional Machinery
-60000
Working Capital Investment
-30000
Cash inflows (Net of tax)
120000
180000
180000
(200000*(1-0.40)
(300000*(1-0.40)
(300000*(1-0.40)
Operating cost (Net of tax)
-90000
-108000
-108000
(150000*(1-0.40)
(180000*(1-0.40)
(180000*(1-0.40)
Tax Saving on Depreciation (See Note below)
3143.8
12490.4
13573.2
Sale Value of Business (Net of tax) See note
$ 200,792.60
Net Cash Flows
-140000
-26856.2
84490.4
286365.8
DCFROR
35.93%
PVF (15%)
1.00000
0.86957
0.75614
0.65752
PV = Net cash Flows * PVF
$ (140,000.00)
$ (23,353.22)
$ 63,886.88
$ 188,290.16
Net Present value = Sum of PVs'
$ 88,823.83
Working Note :
Depreciation on Initial Machine investment :
Cost
110000
110000
110000
7 Year MACRS Depreciation %
14.29%
24.49%
17.49%
Depreciation (First year Dep = 110000*14.29% /2)
7859.5
26939
19239
Depreciation on Additonal Machine investment :
Cost
60000
60000
7 Year MACRS Depreciation %
14.29%
24.49%
Depreciation (First year Dep = 60000*14.29% /2)
4287
14694
Total Depreciation
7859.5
31226
33933
Tax Saving on Depreciation @40%
3143.8
12490.4
13573.2
Sale value of Business (Net of tax):
Sale value Total
$ 250,000.00
Less: Working Capital
$ (30,000.00)
Less: Cost of Assets (110000+60000)
$ (170,000.00)
Add: Total Depreciation
$ 73,018.50
Net Profit
$ 123,018.50
Tax on profit @40%
$ 49,207.40
Sales Value - tax =
$ 200,792.60
Calculation of discounted cash flow rate of return
Year 0
Year 1
Year 2
Year 3
Initial Invetsment
-110000
Additional Machinery
-60000
Working Capital Investment
-30000
Cash inflows (Net of tax)
120000
180000
180000
(200000*(1-0.40)
(300000*(1-0.40)
(300000*(1-0.40)
Operating cost (Net of tax)
-90000
-108000
-108000
(150000*(1-0.40)
(180000*(1-0.40)
(180000*(1-0.40)
Tax Saving on Depreciation (See Note below)
3143.8
12490.4
13573.2
Sale Value of Business (Net of tax) See note
$ 200,792.60
Net Cash Flows
-140000
-26856.2
84490.4
286365.8
DCFROR
35.93%
PVF (15%)
1.00000
0.86957
0.75614
0.65752
PV = Net cash Flows * PVF
$ (140,000.00)
$ (23,353.22)
$ 63,886.88
$ 188,290.16
Net Present value = Sum of PVs'
$ 88,823.83
Working Note :
Depreciation on Initial Machine investment :
Cost
110000
110000
110000
7 Year MACRS Depreciation %
14.29%
24.49%
17.49%
Depreciation (First year Dep = 110000*14.29% /2)
7859.5
26939
19239
Depreciation on Additonal Machine investment :
Cost
60000
60000
7 Year MACRS Depreciation %
14.29%
24.49%
Depreciation (First year Dep = 60000*14.29% /2)
4287
14694
Total Depreciation
7859.5
31226
33933
Tax Saving on Depreciation @40%
3143.8
12490.4
13573.2
Sale value of Business (Net of tax):
Sale value Total
$ 250,000.00
Less: Working Capital
$ (30,000.00)
Less: Cost of Assets (110000+60000)
$ (170,000.00)
Add: Total Depreciation
$ 73,018.50
Net Profit
$ 123,018.50
Tax on profit @40%
$ 49,207.40
Sales Value - tax =
$ 200,792.60
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