Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $1,860,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1,950,000 in annual sales, with costs of $1,060,000. Assume the tax rate is 35 percent and the required return on the project is 14 percent.
Required:
What is the project’s NPV?
To calculate the project’s net present value (NPV), we need to calculate the present value of its cash flows. Here are the step-by-step calculations:
1. Calculate the annual after-tax cash flow for each year:
Annual sales = $1,950,000
Costs = $1,060,000
Depreciation = Initial fixed asset investment / Tax life = $1,860,000 / 3 = $620,000
Taxable income = Annual sales - Costs - Depreciation
Taxes = Taxable income * Tax rate = Taxable income * 0.35
Net income = Taxable income - Taxes
After-tax cash flow = Net income + Depreciation
2. Discount each year's after-tax cash flow to present value:
Year 1: Present value = After-tax cash flow / (1 + Required return)^1
Year 2: Present value = After-tax cash flow / (1 + Required return)^2
Year 3: Present value = After-tax cash flow / (1 + Required return)^3
3. Calculate the project's NPV by summing up the present values of all cash flows:
NPV = Sum of present values of cash flows - Initial fixed asset investment
Let's perform the calculations:
Year 1:
After-tax cash flow = ($1,950,000 - $1,060,000 + $620,000) = $1,510,000
Present value = $1,510,000 / (1 + 0.14)^1 = $1,319,298.25
Year 2:
After-tax cash flow = ($1,950,000 - $1,060,000 + $620,000) = $1,510,000
Present value = $1,510,000 / (1 + 0.14)^2 = $1,155,368.02
Year 3:
After-tax cash flow = ($1,950,000 - $1,060,000 + $620,000) = $1,510,000
Present value = $1,510,000 / (1 + 0.14)^3 = $1,007,325.35
NPV = Sum of present values - Initial fixed asset investment
= ($1,319,298.25 + $1,155,368.02 + $1,007,325.35) - $1,860,000
= $3,481,991.62 - $1,860,000
= $1,621,991.62
Therefore, the project's NPV is $1,621,991.62.