Foley Systems is considering a new investment whose data are shown below. The eq
ID: 2647153 • Letter: F
Question
Foley Systems is considering a new investment whose data are shown below. The equipment would be depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require additional net operating working capital that would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's life. What is the project's NPV? (Hint: Cash flows from operations are constant in Years 1 to 3.)
WACC 10.0%
Net investment in fixed assets (basis) $75,000
Required net operating working capital $15,000
Straight-line depreciation rate 33.333%
Annual sales revenues $75,000
Annual operating costs (excl. depreciation) $25,000
Tax rate 35.0%
Explanation / Answer
Before answering the question, please note the following:
1. Investment made today for purchasing the equipment would lead to cash outflow.
2. Depreciation per annum on the equipment = $ 75,000/3 = $25,000
3. The same investment made in (1) would lead to tax benefit on depreciation. This means whenever base on which tax is to be paid is computed, depreciation is deducted as an expense. In the given case
Taxable base = Annual sales revenue - Annual operating costs (excl depreciation) - Depreciation
= $75,000 - $25,000 - $25,000
= $25,000
4. Depreciation does not lead to cash outflow but is a tax deductible expense.
5. Additional net working capital required at present would lead to cash outflow at present which would be recovered at the end of period 3 as mentioned.
Also this does not impact tax. Hence is not counted when computing tax.
Now to compute NPV, cash flows are to be computed
a. Cash flows at period 0 (Today) = Equipment cost (Outflow) + Net operating working capital (Outflow)
= $75,000 + $ 15,000
=$ 90,000 (Outflow)
b. Cash flows from operations in period 1 to 3 = Annual sales revenue (Inflow) - Annual operating costs (excl depreciation) (Outflow) - Tax(Outflow)
In the above equation, tax is to be computed. Taxable base as computed in (3) above is $25,000. Tax = 35% per annum
Thus, tax = 35% * $25,000
= $ 8,750
Net cash flow per annum from operations (Year 1 to 3)= Annual sales revenue - Annual operating costs (excl depreciation) - Tax
= $ 75,000 - $25,000 - $ 8,750
= $ 41,250 (Inflow)
c. In addition to cash flow from operations, in year 3 net working capital of $ 15,000 invested at period 0 would be recovered as an inflow
Net Present value is computed as below:
Present value
(PV factor * Cash flow)
Thus NPV = $23,852
Year Cash flow Reference above PV factor @ WACC of 10%Present value
(PV factor * Cash flow)
0 ($ 90,000) a 1.0000 ($ 90,000) 1 $41,250 b 0.9091 $37,500 2 $41,250 b 0.8264 $34,091 3 $41,250 + $ 15,000 b & c 0.7513 $42,261 Net present value $23,852