Question

Shanks Corporation is considering a capital budgeting project that involves investing $600,000 in equipment that would have a useful life of 3 years and zero salvage value. The company would also need to invest $20,000 immediately in working capital which would be released for use elsewhere at the end of the project in 3 years. The net annual operating cash inflow, which is the difference between the incremental sales revenue and incremental cash operating expenses, would be $300,000 per year. The project would require a one-time renovation expense of $60,000 at the end of year 2. The company uses straight-line depreciation and the depreciation expense on the equipment would be $200,000 per year. Assume cash flows occur at the end of the year except for the initial investments. The company takes income taxes into account in its capital budgeting. The income tax rate is 35%. The after-tax discount rate is 15%.

Required:

Determine the net present value of the project. Show your work!

Answer 1

Calculation of Net Present value of the project:

Year	Net annual operating cash flow	Depreciation	One time renovation	Profit (PBT)	Tax	Profit after tax	Depreciation	Cash inflow
1	300000	200000	-	100000	35000	65000	200000	265000
2	300000	200000	60000	40000	14000	26000	200000	226000
3	300000	200000	-	100000	35000	65000	200000	265000

Initial cash outflow:

Cost of equipment = $600000

Working capital = $20000

  Total -A = $620000

Operating cash inflows:

Year 1: 265000*0.8696 = $230444

Year 2: 226000*0.7561 = $170879

Year 3 : 265000*0.6575 = $174237

Total -B = $ 575560

End of 3 years; Release of working capital

Year 3 : 20000*0.6575 (C) = $ 13150

Net Present value = B-A+C = 575560-620000+13150

= -31290.