Assume you have just graduated from college with a degree in finance and you are

Question

Assume you have just graduated from college with a degree in finance and you are trying to explain to your boss the importance of identifying and using the appropriate cash flows when you make financial decisions. He is considering investing in a project and he has identified the following cash flows and information that he considers relevant. • Forecast net income for years 1 through 8 of $450,000 per year. • Initial investment in equipment and facility of $2,200,000 • Value of equipment and facility at project’s termination $200,000 • The equipment will be fully depreciated by the project’s end. For simplicity assume equal amounts every year. • The company’s marginal tax rate is 15%

Explanation / Answer

STEP 1:- Computation Of Depreciation

Depreciation = initial cost of equipment value less termination value / life of the asset

= $2,200,000 less $200,000 / 8years

= $2,000,000 / 8

= $ 250,000

STEP2:- Tax Savings Due to Depreciation

Tax saving = Depreciation * Marginal Tax rate

= $ 250,000 * 15%

= $37,500 per year

[Note: Tax gets saved due to claiming depreciation as it reduces income computed which ultimately reduces tax. the tax which was reduced due to claiming depreciation is tax saved which is benefit to be considered while projecting cash flows]

present value factor is used to bring the future cash flows to present value. It was not given in the question. the discounting rate assumed to bring future cash flows to present value be 10%.

STEP3:- Total Cash flows

Year   Net income    Tax saving on depreciation Total cash flow   

1 to 8 years $450,000 per year $37,500 per year $487500per year   

STEP4:-  Computation of Present value cash flows

(1) (2) (3) (4) = (2) * (3)

YEAR CASHFLOWS PRESENT VALUE FACTOR (PVF @ 10%) DISCOUNTED    (note provided) CASHFLOWS

1 $487,500 0.91 $443625   

2 $487,500 0.826 $402675

3 $487,500 0.7513 $366260

4 $487,500 0.6830 $332960

5 $487,500 0.6210 $302740

6 $487,500 0.5644 $275145

7 $487,500 0.5131 $250140

8   $487,500 0.466 $227175

8 $200,000(terminal cashflow) 0.466 $93200

Total present value cashflows = $2693870

STEP5: Considering Net Present Value(NPV)

The difference between present outflow and present value of inflow is called Net present Value. If NPV is positive equipment can be purchased and if NPV is negative euipment should not be purchased.

NPV = Total present value of cash inflow less present value of cash outflow

= $2693870 less $2200000

=$ 493870

Decision:- Since NPV is positive equipment can be purchased. which indirectly means purchasing equipment is profitable to the organisation.

[note: present value factor can be obtained as follows.

Present Value Factor (PVF) of 1st year = (1 / 1 + discounting rate)1 ]

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