6. Hu’s Software Design, Inc.
is considering the purchase of computer
that has an economic life of 4 years and it is expected to have no
salvage value. It will cost $80,000 and it will be depreciated using the
straight line depreciation method. It will save the company $35,000 the
first year and it is assumed that the savings after that will have a growth
rate of –5%. It will also reduce net working capital requirements by
$7,000. The corporate tax rate is 35% and the appropriate discount rate
is 14%. What is the value that the purchase will add to the firm?
Answer : To find the cash flow, formula down below has been used,
Cash flow = (1-tax rate) (operating income) + depreciation
Depreciation Cost :
(straight line formula) = investment cost/economic life of the investment
= $80 000/4
= $ 20 000
This investment reduces the net working capital, thus the initial cost of
investment will added $7 000 and at the end of year 4 cash flow, $7 000
will be deducted.
The growth rate is -5%, which means the revenue will
be less by 5% for each year.
Year Revenue ( with 5% less starting year 2)
1 35 000
2 35 000 (0.05)= 33 250
3 33 250 (0.05) = 31 587.5
4 31 587.5 (0.05) = 30 008.13
The table below shows the simplest way of calculating the cash flow,
Year CF
0 -80,000 + 7,000 = -73,000
1 (1-0.35) x (35,000 – 20,000) + 20 000 = 29,750
2 0.65 (35,000 x 0.95 – 20,000) + 20 000 = 28,612.5
3 0.65 (35,000 x 0.952 – 20 000)+ 20,000 = 27,531.88
4 0.65 (35,000 x 0.953 – 20 000) + 20,000 –7000 =
19,505.28
To calculate the Net Present Value (NPV) we will use the formula below
:
NPV= present values of cash flows – initial investment
cash flow
(1 + i )n
where:
i=Required return or discount rate(in this case is 0.14)
n=Number of time periods(in this case 4 years)
PV = 29,750 + 28,612.5 + 27, 531.88 + 19, 505.28
(1+0.14) (1+0.14)2 (1+0.14)3 (1+0.14)3
= 26 096.49 + 22, 016.39 + 18, 583.23 + 11, 548.69
= 78, 244.8
NPV = - 73, 000 + 78, 244.8
= $ 5, 244.8
14. Healthy Hopes Hospital Supply Corporation is considering an
investment of $500,000 in a new plant for producing
disposable diapers. The plant has an expected life of 4 years.
Sales are expected to be 600,000 units per year at a price of
$2 per unit. Fixed costs excluding depreciation of the plant
are $200,000 per year, and variable costs are $1.20 per unit.
The plant will be depreciated over 4 years using the straight
line method with a zero salvage value. The hurdle rate for the
project is 15% per year, and the corporation pays income tax
at the rate of 34%.
Find:
a) The level of sales that would give a zero accounting profit.
b) The level of sales that would give a 15% after-tax accounting
rate of return on the $500,000 investment.
c) The IRR, NPV, and payback period (both conventional and
discounted) if expected sales are 600,000 units per year.
d) The level of sales that would give an NPV of zero.
Answer :
Depreciation Cost :
(straight line formula) = investmencost /economic
life of the investment
= $500 000/4
= $ 125 000
a) Formula for zero accounting profit is :
Break-even sales = fixed cost + depreciation
Contribution margin
B-E sales = $325,000 per year = 406,250 units per
year $.80 per unit
b) To earn a 15% accounting ROI, the after tax profit
(net income) has to be:
0.15 x $500,000 = $75,000
That means before-tax profit has to be $75,000/0.66 =
$113,636.
To earn this additional profit, the new breakeven quantity
must increase 142,045 units per year (required profit
before taxes/ contribution margin = $113,636/$.80) to a
total of 548,295 per year.
c) If 600,000 units per year can be sold, then the expected
annual net cash flow can be derived using the formula:
CF = net income + depreciation
= (1 - tax rate)(Revenue - total operating costs) +
depreciation
= 0.66 x ($1,200,000 - $720,000 - $325,000) +
$125,000
= $227,300 per year
NPV = present values of cash flows – initial investment
= PVPMT ($227,300, 15%,4) – 500, 000
= 648, 936.58 – 500, 000
= $ 148, 936.58
In order to calculate the IRR of the investment,
trial and error method has been used. As the
name implies, this method guesses the rate of
return that will give an NPV of zero, check it by
running the calculation with the rate that has
been guessed, and then adjust the percentage up
or down until get as close to zero as possibly
can.
NPV= PVPMT ($227,300, 29.09%,4) – 500, 000 = 0
Thus, the IRR is 29.09%
The discounted payback is : 2.87 years
where( 130, 476.37/ 149, 453.44 = 0.87)
Conventional payback period = $500,000/$227,300 per year = 2.2 years
Annual CF Discounted Cumulative
CF Discounted
CF
Initial cash (500, 000) (500, 000) (500, 000)
outlay
1 227,300 197, 652.17 (302, 347.83)
2 227,300 171, 871.46 (130, 476.37)
3 227,300 149, 453.44 18, 977.07
4 227,300 129, 959.51
d) To find the level of sales that would give an NPV of zero, we
have to find the cash flow from the initial investment :
500, 000 = PMT{ 1- 1/ (1+0.15)4}
0.15
= 175, 132.68
Now we must find the number of units per year (Q), that
corresponds to an operating cash flow of this amount. A little
algebra reveals that the breakeven level of Q is units per year:
CASH FLOW = NET PROFIT + DEPRECIATION
= 0.66(.8Q – 325,000) + 125,000 = 175,133
= 0.66(.8Q – 325,000) = 50,133
0.8Q – 325,000 =50,133/.66 = 75,959
Q = 400,959 = 501,199 units per year
0.8
