A company is considering the purchase of equipment costing $84000 which will per

Question

A company is considering the purchase of equipment costing $84000 which will permit it to reduce its existing labour cost by $21000 each year for twelve years. The company estimates that it will have to spend $2000 every two years overhauling the equipment. The equiment may be depreciated using straight line depreciation over 12 years for tax purposes. The company tax rate is 30 cents in the dollar and the after corporate tax cost of capital is 10% per annum. Assume: 1. Salvage value of zero. 2. The outlay of $84000 occurs at time zero. 3. All other cash flows including, tax payments and credits are made at the end of the year. 4. No overhaul is required in year 12. What is the NPV to the nearest dollar? Be careful not to round until the last calculation.

Explanation / Answer

WeTStep1 : We need to convert all the cashflows in post tax.

We will have a annual cost saving of $21000. Post Tax it would be $ 21000*70% = $14700.

We will have outflow of $2000 every two years. Post tax it would be $ 2000*70% = $1400.

We would also have a tax saving on account of depreciation annully. It would be = 84000/12*70% = $4900.

Adding these three, would be getting the net post tax cash Inflows.
It would be $19600 on the years wheen there would be no maintainence and $ 18200 on the years when there would be maintainence.

Then we would be discounting the net cashflows @ 10% (Post Tax cost of capital)

We would be minusing the $84000 (Outflow at time 0) to get the NPV.

The calculation would be :

Thus as calculated the NPV is $45005.9

Time Line Year Saving in Labour cost(After Tax) Outflow on Overhauling labour equipment (After Tax) Savings on account of depreciation. (Tax Saving) Net After Tax cash Inflow PV Factor @10% after tax cost of capital PV 1 14700 4900 19600 0.909090909 17818.18 2 14700 -1400 4900 18200 0.826446281 15041.32 3 14700 4900 19600 0.751314801 14725.77 4 14700 -1400 4900 18200 0.683013455 12430.84 5 14700 4900 19600 0.620921323 12170.06 6 14700 -1400 4900 18200 0.56447393 10273.43 7 14700 4900 19600 0.513158118 10057.9 8 14700 -1400 4900 18200 0.46650738 8490.434 9 14700 4900 19600 0.424097618 8312.313 10 14700 -1400 4900 18200 0.385543289 7016.888 11 14700 4900 19600 0.350493899 6869.68 12 14700 -1400 4900 18200 0.318630818 5799.081 Total 129005.9 Less : Outflow at time 0 84000 Net Present Value 45005.9

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