Question 5 Investment Analysis (20 points) A proposed cost saving investment has

Question

Question 5 Investment Analysis (20 points) A proposed cost saving investment has a five-year life and an instaliled cost of $800,000. The depreciation schedule for the equipment is three year MACRS for which the annual factors are 0.333, 0.4445, 0.1481, 0.0741. The equipment has an estimated salvage value in year 5 of $65,000 before taxes. The company's required return on cost-saving investments is 12% and its tax rate if 35%. The company expects to borrow the funds necessary to make the investment and pay interest at the rate of 7%. The loan will be interest-only for five years with the repayment of principal at the end of the life of the project A Net working Capital investment of $50,000 will be required immediately and 50% of that will be recovered at the end of the third year of the project life. The balance of the NWC will be recovered at the end of year five Management believes that the annual cost savings will be either $100,000 or $400,000 depending on whether the economy is weak (40%) or strong (60%) for the next five years. An expected cost of the project is that the manager of the project will hire an assistant who will cost $45,000 per year before taxes for the first three years of the project. In the last two years of the project, the assistant will not be needed for the project and may be laid off or promoted to another project, depending on the need in the company for their skill set. Calculate the Net Present Value of this project, then state whether the company should invest? Explain.

Explanation / Answer

Loan amount = initial investment to purchase machine + initial working capital required

= 800000+50000

= 850000

interest only payment every year = 850000*7% = 59500

Calculation of Cost saving per year -

cost saving per year = weak economy prob.*weak economy cost saving + strong economy prob.*strong economy cost saving

= 40%*100000 + 60%*400000

= 40000 + 240000

= 280000

Calcualtion of Net present value of the project -

as NPV is coming positive 166555.3 so the company can invest in this project.

Please comment in case ofany clarification required.

MACRS Rate 0.333 0.4445 0.1481 0.0741 Year 1 2 3 4 5 NPV Revenue 280000 280000 280000 280000 280000 less Dep.(cost of assets * MACRS rate) 266400 355600 118480 59280 0 less Cost of assistant 45000 45000 45000 less Interest cost 59500 59500 59500 59500 59500 EBIT -90900 -180100 57020 161220 220500 less income tax @ 35% 0 0 19957 56427 77175 EAT -90900 -180100 37063 104793 143325 add Net working capital recovered 25000 25000 add salvage value after tax 65000*(1-t) 42250 add Depriciation 266400 355600 118480 59280 0 Repayment of principal loan -850000 Cash flow after tax 175500 175500 180543 164073 -639425 Discounting @ 12% 0.892857 0.797194 0.71178 0.635518 0.567427 Net present value 156696.4 139907.5 128506.9 104271.4 -362827 166555.3

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