Question

Oxygen Optimization is considering buying a new purification system. The new system would be purchased today for 17,200 dollars. It would be depreciated straight-line to 2,200 dollars over 2 years. In 2 years, the system would be sold and the after-tax cash flow from capital spending in year 2 would be 3,500 dollars. The system is expected to reduce costs by 6,100 dollars in year 1 and by 12,400 dollars in year 2. If the tax rate is 50 percent and the cost of capital is 5.17 percent, what is the net present value of the new purification system project?

Answer 1

Given purchase price at t= 0 = $ 17,200

Also given that value after depreciation after 2 years = $ 2,200.

Hence, amount of depreciation per annum = (17,200 -2,200) / 2 = 7,500; and tax savings on such depreciation = 7,500 * 0.50 = 3,750 per annum.

PARTICULARS	AMOUNT
Year 1 cashflows ( savings in expenses; post tax)	= 6,100*0.50 = 3,050
Add: Tax savings on depreciation for Year 1	= 3,750
Total Present value of savings as of Year 1 (PV factor @ 5.17%)	= (3,050 + 3,750) *0.9508 = 6,465
Year 2 : Total PV of year 2 savings = post tax saved costs + tax savings on depreciation + after tax capital cash inflow	=( (12,400*0.50) + 3,750 + 2,200) * 0.9041 = 12,150 * 0.9041 = 10,985

Therefore, Net Present Value of new purification system = 6,465 + 10,985 - 17,200 = $ 250.