Sub-Prime Loan Company is thinking of opening a new office, and the key data are
ID: 2667482 • Letter: S
Question
Sub-Prime Loan Company is thinking of opening a new office, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new office. The equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No new working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)WACC
10.0%
Opportunity cost
$100,000
Net equipment cost (depreciable basis)
$65,000
Straight-line depr. rate for equipment
33.333%
Sales revenues, each year
$122,000
Operating costs (excl. depr.), each year
$25,000
Tax rate
35%
(Points : 10)
$10,655
$9,483
$13,318
$11,081
$12,040
Explanation / Answer
That answer is incorrect. The correct answer is the following:
d. $12,271
WACC - 10%
Opportunity cost - $100,000
Net equipment cost (depreciable basis) - $65,000
Straight-line deprec. rate for equipment - 33.333%
Sales revenues, each year - $123,000
Operating costs (excl. deprec.), each year - $25,000
Tax rate - 35%
Year 1
Tax benefit of depreciation: $7,583.33 (65,000/3*0.35)
After tax cash flows: $63,700.00
Future cash flows: $71,283.33 (7,583.33 + 63,700.00)
Year 2
Tax benefit of depreciation: $7,583.33 (65,000/3*0.35)
After tax cash flows: $63,700.00
Future cash flows: $71,283.33 (7,583.33 + 63,700.00)
Year 3
Tax benefit of depreciation: $7,583.33 (65,000/3*0.35)
After tax cash flows: $63,700.00
Future cash flows: $71,283.33 (7,583.33 + 63,700.00)
After tax cash flows:
Revenue: $123,000.00
Expenses w/o deprec: $25,000.00
Income before taxes: $98,000.00 (123,000 - 25,000)
Taxes: $34,300.00 (98,000 * 0.35)
After tax annual profits: $63,700.00 (98,000 - 34,300)
Net present value:
Initial investment: $165,000.00 (100,000 + 65,000)
Present value of future cash flows : $177,271.10
Net present value (difference): $12,271.10 (177,271.10 - 165,000)