ABC Co. is contemplating an $18,000 investment in a methane gas generator. They
ID: 1117008 • Letter: A
Question
ABC Co. is contemplating an $18,000 investment in a methane gas generator. They estimate gross income will be $4500 the first year and increase by S500 each year over the next 10 years. Expenses of $300 the first year would increase by $250 each year over the next 10 years. ABC will depreciate the generator by MACRS depreciation, assuming a 7-year property class. A 10-year-old methane generator has no market value. The combined income tax rate is 45%. (Remember that recaptured depreciation is taxed at the same 45% rate.) (a) Construct the after-tax cash flow for the 10-year project life (b) Determine the after-tax rate of return on this investment. ABC Co. thinks it should be at least 8% (c) If ABC Co. could sell the generator for $10,000 r, what would the rate at the end of the fifth y of return be?Explanation / Answer
a) After tax cash flows are provided below
Depreciation rates are 14.29, 24.49, 17.49, 12.49, 8.92. 8.92 , 8.92 , 4.46
There is no salvage value so no gain tax.
Find the rate or return that makes the PW = 0
We fnd two interest rates, 15% at which PW is 1005.74. And at 20% where PW = -2075.55
ROR = 15% + (20% - 15%)*(1005.74 / (1005.74 - (-2075.55)) = 16.632%
Since company expects MARR at 8%, the equipment is purchased
For the last part last year depreciation (half value at 4.46% of 18000) is 802.8. Hence book value is 18000 - 13179.6 = 4820.40. With salvage value of $10000, capital gain = 5179.60. Capital gain tax = 45% x 5179.60 = 2331
Use interpolation to find ROR = 12.056%
Year 0 1 2 3 4 5 6 7 8 9 10 Income statement Revenues 4500 5000 5500 6000 6500 7000 7500 8000 8500 9000 Expenses 300 550 800 1050 1300 1550 1800 2050 2300 2550 Depreciation 2572.2 4408.2 3148.2 2248.2 1605.6 1605.6 1605.6 802.8 0 0 Taxable income 1627.8 41.8 1551.8 2701.8 3594.4 3844.4 4094.4 5147.2 6200 6450 Income tax 733 19 698 1216 1617 1730 1842 2316 2790 2903 Net income 895 23 853 1486 1977 2114 2252 2831 3410 3548 Cash flow statement Net income 895 23 853 1486 1977 2114 2252 2831 3410 3548 Depreciation 2572.2 4408.2 3148.2 2248.2 1605.6 1605.6 1605.6 802.8 0 0 Investment activities Investment -18000 Salvage 0 Gains tax 0 Net cash flow -18000 3467 4431 4002 3734 3583 3720 3858 3634 3410 3548