Dog Up Franks is looking at a new sausage system with an ins

Dog Up! Franks is looking at a new sausage system with an installed cost of $515,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $77,000. The sausage system will save the firm $195,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $36,000. If the tax rate is 35 percent and the discount rate is 9 percent, what is the NPV of this project?

Solution

Franks is looking at a new sausage system with an installed cost of $420,000. This cost will be depreciated straight-line to zero over the project\'s five-year life, at the end of which the sausage system can be scrapped for $60,000. The sausage system will save the firm $130,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $28,000. If the tax rate is 34 percent and the discount rate is 10 percent, what is the NPV of this project?

•Annual depreciation = $515,000/5

•Annual depreciation = $103,000

•Now, we calculate the aftertax salvage value. The aftertax salvage value is the market price minus (or plus) the taxes on the sale of the equipment, so:

•Aftertax salvage value = MV + (BV – MV)tc

•Very often the book value of the equipment is zero as it is in this case. If the book value is zero, the equation for the aftertax salvage value becomes:

•Aftertax salvage value = MV + (0 – MV)tc

•Aftertax salvage value = MV(1 – tc)

•We will use this equation to find the aftertax salvage value since we know the book value is zero. So, the aftertax salvage value is:

•Aftertax salvage value = $77,000(1 – 0.35)

•Aftertax salvage value = $50,050

•Using the tax shield approach, we find the OCF for the project is:

•OCF = $195,000(1 – 0.35) + 0.35($103,000)

•OCF = $162,800

•Now we can find the project NPV. Notice we include the NWC in the initial cash outlay. The recovery of the NWC occurs in Year 5, along with the aftertax salvage value.

PVIFA_9%,5 = [1 - (1+0.09)^-5]/0.09 = 3.89

•NPV = –$515,000 – 36,000 + $162,800(PVIFA _9%,5) + [($50,050 +36,000) / 1.09⁵]

•NPV = $138161,82