Question

Suppose a firm is considering an investment. The investment will cost $250,000 and return $60,000 per year for each of the next 5 years. Suppose the tax system allows straight-line depreciation with a 10-year asset life. The firm uses a 10 percent discount rate (that is, the opportunity cost of funds is 10 percent) and the corporate tax rate is 35 percent. What is the present discounted value of the returns from the investment? Should the firm make the investment?

Answer 1

Solution

Dep per year = $250,000 / 10 = $25,000

Now

Every year taxable income = $60,000 - $25,000 = $35,000

After tax Income = $35,000 - ( $35,000 * 35% ) = $22,750

Now Operating Cash flow every year = $22,750 + $25,000 = $47,750

Now Present discounted value of the returns from the investment = $47,750 * PVAF ( 10% , 5 ) + $125,000 * PVF (10% , 5 )

= ( $47,750 * 3.791 ) + ( $125,000 * 0.621 )

= $258,625.23

Now as the Present discounted value of the returns from the investment is greater than initial Cost

So the firm can make investment

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