CMA Study Group

Please help to solve

  • 1.  Please help to solve

    Posted 01-27-2020 06:00 AM
    A company is considering the purchase of a new production machine and is not sure whether the project fulfills its investment objective. The company requires that all investments must have a positive net present value (NPV). The machine costs $100,000 and will be depreciated for tax purposes on a straight-line basis over its useful life of 5 years. After 5 years the used equipment will be sold. The project requires an initial investment in working capital of $20,000 and will generate $30,000 of pretax operating cash inflow annually. The company has a 25% effective income tax rate and uses a 10% discount rate for investment projects. Of the four estimated ranges shown below, which is the approximate minimum sales price that must be realized for the used equipment at the end of Year 5 in order to achieve a positive NPV on this project?

    A. $5,250-$5,625
    B. $7,000-$7,500
    C. $10,000-$13,500
    D. $800-$1,200

    Syed Yousuf Jamal


  • 2.  RE: Please help to solve

    Posted 15 days ago
    Answer (B) is correct.
    The NPV must be calculated without a value for the used equipment. The initial outflow is $120,000 ($100,000 machine cost plus $20,000 investment in working capital). The annual cash inflows would be $30,000, but that would be reduced by the $2,500 of income taxes. Thus, the net inflows each year would be $27,500 {[$30,000 cash inflow × (1 – .25 tax rate)] + ($20,000 depreciation × .25 tax rate)}. The inflows from termination equal the $20,000 of working capital recovered, plus the selling price of the used equipment, minus the taxes on the sale of the fully-depreciated equipment. These amounts would then be discounted at 10%, as follows:
    $27,500 × 3.791
    20,000 ×   .621
    Partial present value
    Less: Initial investment
    Amount needed at sale
    $    3,327.50
    The $3,327.50 represents the present value of the amount needed from the after-tax sale of the used machine. In other words, (S – .25S) × .621 = $3,327.50. Dividing both sides of the equation by .621 yields .75S = $5,358.29, or S = $7,144.39.

    Ammar Aldubaisi
    Saudi Arabia