Question

Winthrop Company has an opportunity to manufacture and sell a new product for a five-year period. To pursue this opportunity, the company would need to purchase a piece of equipment for $145,000. The equipment would have a useful life of five years and zero salvage value. It would be depreciated for financial reporting and tax purposes using the straight-line method. After careful study, Winthrop estimated the following annual costs and revenues for the new product:

Annual revenues and costs:
Sales revenues	$	280,000
Variable expenses	$	135,000
Fixed out-of-pocket operating costs	$	73,000

The company’s tax rate is 30% and its after-tax cost of capital is 16%.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. Calculate the annual income tax expense that will arise as a result of this investment.

2. Calculate the net present value of this investment opportunity. (Round your final answer to nearest whole dollar.)

Answer 1

1. Annual income tax expense that will arise as a result of this investment is:

Particulars	Amount ($)
Revenues	280,000
Less:
Variable expenses	135,000
Fixed out of pocket operating costs	73,000
Depreciation on equipment (145,000/5)	29000
Total expenses	237,000
Income before tax	43,000
Income tax (30% of 43,000)	12,900

2. Net present value of this investment opportunity is

Cost of equipment required	($145,000)						($145,000)
Annual cash inflows		59,100	59,100	59,100	59,100	59,100	$295,500
Net Cash Flow	($145,000)	$59,100	$59,100	$59,100	$59,100	$59,100	$150,500
Discount rate 16% , Life 5 years
Present Value factor	1	0.862	0.743	0.641	0.552	0.476
Present Value of Net Cash flow	-145,000	50,948	43,921	37,863	32,640	28,138	$48,511
Net Present value	-145,000	50,948	43,921	37,863	32,640	28,138	$48,511