Foley Systems is considering a new investment whose data are shown below. The eq
ID: 2648203 • 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 no additional net operating working capital. Revenues and operating costs are expected to be constant over the project's life. The tax rate is 35%. What is the project's NPV, IRR, Discounted Payback and Profitability Index? (Hint: Cash flows from operations are constant in Years 1 to 3.)
Cost of Capital
10.00%
Net Investment
$75,000
Revenue
$75,000
Operating Costs (excluding depreciation)
$50,000
Depreciation Rate
33.33%
Tax Rate
35.00%
Cost of Capital
10.00%
Net Investment
$75,000
Revenue
$75,000
Operating Costs (excluding depreciation)
$50,000
Depreciation Rate
33.33%
Tax Rate
35.00%
Explanation / Answer
Profit before tax every year = 75000-50000-25000 = 0 hence no tax and Profit after tax = 0
Hence Operating cash flow = Profit after tax + depreciation = 25000 every year
Now we know the initial investment and operating cash flow for 3 years, which is 25,000 per year,
Now we know that IRR is the rate where NPV = 0 or discounted cash inflows are equellant to discounted cash outflows. to get IRR, we need to solve the below :
75000 = 25000/(1+r) + 25000/(1+r)^2 + 25000/(1+r)3
Solving this, we get IRR = 0%
Discounted payback = Projects where NPV is negative, don't have discounted payback period because, discounted inflows will never be equal or above the outflows. Hence there will be no disounted payback for this project.
Profitability index = present value of discounted cash inflows/ PV of cash outflows
= 62,171/75000
which is below 1 hence project to be rejected.
Year Cash flow Discounting factor @ 10% Discounted cash flow 0 -75000 1.0000 -75,000 1 25000 0.9091 22,727 2 25000 0.8264 20,661 3 25000 0.7513 18,783 NPV (Sum of DCF) -12,828.70