Question

Company Z is evaluating a project that will increase annual sales by $150,000 and annual cash costs by $115,000. The project will initially require $98,000 in fixed assets that will be depreciated straight-line to a zero book value over the 4-year life of the project. The applicable tax rate is 32 percent. What is the NPV of this project if the required rate of return is 7% and the fixed assets required for the project will be scrapped at the end of the project?

Answer 1

To calculate the NPV of Company Z's project, annual incremental cash flows are determined by subtracting increased costs and taxes from increased sales, factoring in depreciation. These cash flows are then discounted at a rate of 7%, and the NPV is found by subtracting the initial investment.

Step-by-step explanation:

Calculating the Net Present Value (NPV) of Company Z's Project

To calculate the NPV of Company Z's project, we must consider the inflows and outflows of cash over the project's life, taking into account the initial investment, incremental cash flows, depreciation, taxation, and the final scrapping of assets at the end of the project. We will use a required rate of return of 7% for discounting the cash flows.

Step-by-Step Calculation

1. Calculate annual depreciation: $98,000 / 4 years = $24,500 per year.
2. Calculate annual taxable income: Incremental sales - Incremental costs - Depreciation = $150,000 - $115,000 - $24,500 = $10,500.
3. Calculate annual taxes: $10,500 x 32% = $3,360.
4. Calculate net annual cash flow: Incremental sales - Incremental costs - Taxes = $150,000 - $115,000 - $3,360 = $31,640.
5. Assume scrap value of the fixed assets is $0 at the end of year 4.
6. Discount each of the cash flows at the 7% discount rate and sum them up minus the initial investment to find the NPV.

Considering the tax savings from depreciation and that the assets will be scrapped with no salvage value, we can now calculate NPV using the above steps and the provided required rate of return.