Question

Assume that a firm can invest an initial outlay of $100,000 in a 10-year project that yields EBITDA of $22,000 per year. The firm’s tax rate is 40% and the cost of capital is 12%.

a. Calculate the NPV of the project using the straight line method of depreciation for tax purposes. Should the firm accept the project?

b. Calculate the NPV of the project using the sum-of-years-digits accelerated depreciation method for tax purposes. (You may have to look up this method.) Should the firm accept the project?

Answer 1

a) Initial outlay = 100,000

Tenure = 10 years

Straight line depreciation = 100,000 / 10 = 10,000 per year

So, EBIT = EBITDA - Depreciation

= 22,000 - 10,000

= 12,000

Now, supposing there is no interest involved, then

Tax = 40% * 12,000

= 0.40 * 12,000

= 4,800

PBT = 12,000 -4,800

= 7,200

So,7200 is the net cash inflow which will be used in NPV calculation.

PV = 7200 * PVIFA at 12% for 10 years

PV = 7200 * 5.6502

PV = 40,681.44

NPV = PV - Initial investment

= 40,681.44 -100,000

= - 59,318.56

As the NPV is negative so it should not be accepted.