Question

Better Tires Corp. is planning to buy a new tire making machine for $80,000 that would save it $40,000 per year in production costs. The savings would be constant over the project's 3-year life. The machine is to be linearly depreciated to zero and will have no resale value after 3 years.

The appropriate cost of capital for this project is 16% and the tax rate is 21%.

Part 1

What is the free cash flow in each year of operation (years 1 to 3)?

Part 2

What is the NPV of this project?

Answer 1

Part 1:

Particulars	Amount
Annual saving	40000
Less: Annual Depreciation	26667
Taxable annual income	13333
Less: Tax @ 21%	2800
After Tax Annual Income	10533
Add: Annual Depreciation	26667
Annual Cash Inflow	37200
PV of Annual Cashflow at Year 1[37200/(1.16)1] (A)	32069
PV of Annual Cashflow at Year 2[37200/(1.16)2] (B)	27645
PV of Annual Cashflow at Year 3[37200/(1.16)3] (C)	23832
PV of Annual Cashflows (A) + (B) + (C)	83546

Part 2:

NPV = PV of Annual Cashflows - Cost of Machine

NPV = 83546 - 80000

NPV = 3546

As calculated above,NPV is positive hence we can purchase the machine.