A proposed cost saving investment has a five year life and an installed cost of

Question

A proposed cost saving investment has a five year life and an installed cost of $800,000. The depreciation schedule for the equipment is three year MACRS for which the annual factors are .333, .4445, .1481, .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 of 35%. The company expects to borrow the funds neccesary to make the investment and pay the 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 immediatley 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 dpending on wether the economy is weak (40%) or stron (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 wether the company should invest?

Explanation / Answer

Loan amount = 800000+50000

= 850000

interest amt. per year = 850000*7%

= 59500 per year

cost saving per year = 100000*40% + 400000*60%

= 40000 + 240000

= 280000

Calculation of Present value from the project -

The initial investment would be 0 as all the invested amount has been taken on loan which would be repaid at the end of the life of the project/5th year.

According to the present value method, the company should invest in this project as NPV is coming positive.

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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