Question

Please show work step by step, and no excel. Thank you!

(Basic capital budgeting) An investment of $30,000 will be depreciated straight line for 10 years down to a zero salvage value. For its 10 year life, the investment will generate annual sales of $12,000 and annual cash operating expenses of $2,000. Although the investment is depreciated to a zero book value, it should sell for $3,000 in 10 years. The marginal income tax rate is 40% and the cost of capital is 10%.

1. What are the net operating cash flows after tax?
2. What is the NPV of the investment?

Answer 1

Answer a.

Initial Investment = $30,000
Useful Life = 10 years

Annual Depreciation = Initial Investment / Useful Life
Annual Depreciation = $30,000 / 10
Annual Depreciation = $3,000

Annual Operating Cash Flow = (Sales - Costs) * (1 - tax) + tax * Depreciation
Annual Operating Cash Flow = ($12,000 - $2,000) * (1 - 0.40) + 0.40 * $3,000
Annual Operating Cash Flow = $7,200

Answer b.

Salvage Value = $3,000

After-tax Salvage Value = $3,000 * (1 - 0.40)
After-tax Salvage Value = $1,800

Cost of Capital = 10%

NPV = -$30,000 + $7,200 * PVA of $1 (10%, 10) + $1,800 * PV of $1 (10%, 10)
NPV = -$30,000 + $7,200 * 6.14457 + $1,800 * 0.38554
NPV = $14,935

So, NPV of the investment is $14,935