4. You have been asked by the president of your company to evaluate the proposed
ID: 2804844 • Letter: 4
Question
4. You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck’s basic price is $50,000 and it will cost another $10,000 to modify it for special use by your firm. The truck falls into a five-year depreciation class and will be depreciated to zero over the five-year period. The truck is actually expected to be sold for $20,000 after three years when the project is ended. Use of the truck will require an increase in net working capital of $2,000 (spare parts). The truck will have no effect on revenue, but it is expected to save the firm $22,000 per year in before-tax operating costs, mainly labor. The firms marginal tax rate is 40 percent and the required rate of return on the project is 13 percent. What should you do?
Explanation / Answer
Initial Investment = Basic price + Modification cost + capital cost
= $ 50,000 + $ 10,000 + $ 2,000 = $ 62,000
Depreciation Schedule:
Year
Initial Book Value
MACRS %
Annual Depreciation
1
$ 60,000
15.00%
$ 9,000
2
$ 60,000
34.00%
$ 20,400
3
$ 60,000
20.40%
$ 12,240
4
$ 60,000
12.24%
$ 7,344
5
$ 60,000
11.30%
$ 6,780
6
$ 60,000
7.06%
$ 4,236
Calculation of successive cash flows:
Year 1
Year 2
Year 3
Before Tax Operating cost savings
$ 22,000
$ 22,000
$ 22,000
Less: Depreciation
$ 9,000
$ 20,400
$ 12,240
Taxable Income
$ 13,000
$ 1,600
$ 9,760
Tax @ 30 %
$ 3,900
$ 480
$ 2,928
Add: Depreciation
$ 9,000
$ 20,400
$ 12,240
Net Operating Cash Flow
$ 12,900
$ 20,880
$ 15,168
Salvage value on year 3rd = $ 20,000
Salvage Value
$ 20,000
Book value
$ 12,240
Taxable Amount
$ 7,760
Tax @ 40%
$ 3,104
Total gain
$ 16,896
Cash flow on year 3rd = $ 15,168 + $ 16,896 + $ 2,000 = $ 34,064
Calculation of NPV
Year
Cash Flow
PV Factor
PV
0
($62,000)
1
($62,000)
1
$ 12,900
0.884955752
$ 11,415.93
2
$ 20,880
0.783146683
$ 16,352.10
3
$34,064
0.693050162
$ 23,608.06
NPV
$ (10,623.91)
As NPV is negative, the truck should not be purchased.
Year
Initial Book Value
MACRS %
Annual Depreciation
1
$ 60,000
15.00%
$ 9,000
2
$ 60,000
34.00%
$ 20,400
3
$ 60,000
20.40%
$ 12,240
4
$ 60,000
12.24%
$ 7,344
5
$ 60,000
11.30%
$ 6,780
6
$ 60,000
7.06%
$ 4,236
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