I have included the questions below for reference.
FITCO is considering the purchase of new equipment. The equipment costs $350,000, and an additional $110,000 is needed to install it. The equipment will be depreciated straight-line to zero over a five-year life. The equipment will generate additional annual revenues of $265,000, and it will have annual cash operating expenses of $83,000. The equipment will be sold for $85,000 after five years. An inventory investment of $73,000 is required during the life of the investment. FITCO is in the 40 percent tax bracket and its cost of capital is 10 percent. What is the project NPV?
Answer C = 97,449. Agreed. Notice there would not be a BV as equipment has depreciated fully.
2) After estimating a project’s NPV, the analyst is advised that the fixed capital outlay will be revised upward by $100,000. The fixed capital outlay is depre- ciated straight-line over an eight-year life. The tax rate is 40 percent and the required rate of return is 10 percent. No changes in cash operating revenues, cash operating expenses, or salvage value are expected. What is the effect on the project NPV?
Answer B = $73,325 decrease.
Disagree. This only takes into consideration the depreciation change. However, the problem depreciates the FCInv at 8 years, which means that at year 5 when it is sold, it would still have a book value. Maybe I don’t get it, but it appears to me that question #2 does not take into consideration the tax savings the FCInv would generate by selling the equipment at a loss [85k - (85k - 210k)(.40)]
The answer in the book only adjusts for depreciation and its effects on NPV. The problem clearly states that the project still has 5 years of CF and doesn’t say the equipement is sold at year 8 instead of year 5. It only says FCInv increased by 100k and is depreciated by 8 years instead of 5. So wouldn’t FCInv would still have BV, therefore it needs to be included in TNOCF?
How is this not considered? Any help would be greatly appreciated.
Dominion Company is evaluating two mutually exclusive projects: The Pinto grinder involves an outlay of $100,000, annual after-tax operating cash flows of $45,000, an after-tax salvage value of $25,000, and a three-year life. The Bolten grinder has an outlay of $125,000, annual after-tax operating cash flows of $47,000, an after-tax salvage value of $20,000, and a four-year life. The required rate of return is 10 percent. The net present value (NPV) and equivalent annual annuity (EAA) of the Pinto grinder are $30,691 and $12,341, respectively. Whichever grinder is chosen, it will have to be replaced at the end of its service life. The analyst is unsure about which grinder should be chosen.
I got a much higher NPV and EAA for Bolten due to including depreciation when calculating Cash Flow. I can’t understand why depreciation is not added back to Cash Flows for this problem.
Anyone that solved this problem right out the gate: To solve this problem, I just went ahead and dived in to calculate NPV and EAA for Bolten–obviously got it wrong. Was I supposed to calculate the NPV/EAA for Pinto and conclude that the writer of the problem did not add depreciation, then to compare apples to apples do not calculate depreciation for Bolten?
Hi Gpessah, re question 23. The information given states “after tax operating cash flows” i.e EBIT(1-tc), thus it has already taken into account the depreciation. Hope this helps. I noticed thius in a few other problems too, particularly when “after tax salvage value” is given etc…a reminder to watch the wording of information given I guess.
Thanks for the response. That sounds about right. Gotta make sure I read it carefully as operating Income and Operating CashFlows can completely throw you off with respect to the treatment of Depreciation. Thanks for answering my question. Any thoughts on the one above it?
Hi Gpessah, I agree this is fishy. Hopefully someone can provide any perceived clarity on this one. Ironically I solved this squestion correctly as I didn’t read the information properly, but if I had I can see I would end up with the same question as you.
For problem #2, I believe I have the answer to why the CFA’s answer is correct.
The question says “after estimating a project’s NPV” I believe the word " a" is what tricked me here. I believe the author of the question was not intending to reference the previous problem, I believe he was just referencing a projects NPV.