Question

The Alpha Medical Equipment Co. is in the market for packaging equipment that will cost $60,000. This equipment will reduce labor costs by $20,000/year. The equipment has a useful life of five years and falls into the three year property class of MACRS. Salvage value is $10,000. Alpha’s tax rate is 20%. Alpha has no debt, but its beta is 1.20, the market return is 11.5%. The 30-year Treasury is 6.00%. Using the given information, what is the NPV of this project? What is the IRR? Should we accept it?

Answer 1

Cost of capital, r = Rf + beta x (Rm - Rf) = 6% + 1.20 x (11.5% - 6%) = 12.60%

Alpha	0	1	2	3	4	5
MACRS %		33.33%	44.45%	14.81%	7.41%
Investment	-60,000
Salvage						10,000
Savings		20,000	20,000	20,000	20,000	20,000
Depreciation		-19,998	-26,670	-8,886	-4,446	0
EBT		2	-6,670	11,114	15,554	20,000
Tax (20%)		0	1,334	-2,223	-3,111	-4,000
Net Income		2	-5,336	8,891	12,443	16,000
Cash Flows	-60,000	20,000	21,334	17,777	16,889	24,000
NPV	$10,806.16
IRR	19.67%

Depreciation = Investment x MACRS %

Cash Flows = Investment + Salvage x (1 - tax) + Net Income + Depreciation

NPV and IRR can be calculated using the same function on a calculator or excel with 12.60% rate.

As NPV > 0 and IRR > 12.6%, the project should be accepted.