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  • #232504
    Charanpreet Kaur
    Participant

    Hi There,

    I got confused regarding what cash-flow I should take while calculating NPV. Like in some questions we take cash-flow(before tax)like in below example 1 and in some cases we are taking after-tax. So how do I know if I have to take before tax/after tax cashflow. Thanks

    Example1:12. Question ID: CMA 1295 4.12 (adapted) (Topic: Net Present Value Method)

    Willis Inc. has a cost of capital of 15% and is considering the acquisition of a new machine which costs $400,000 and has a useful life of 5 years. Willis projects that earnings and cash flow will increase as follows:

    Net YearAfter-Tax
    Earnings
    Cash Flow
    1$100,000 $160,000  
    2100,000 140,000  
    3100,000 100,000  
    4100,000 100,000  
    5200,000 100,000  

    Example2: its taking after tax cash flow in calculating NPV

    Question ID: ICMA 10.P2.323 (Topic: Net Present Value Method)

    Lunar Inc. is considering the purchase of a machine for $500,000 which will last 5 years. A financial analysis is being developed using the following information.

     Year 1Year 2Year 3Year 4Year 5
    Unit sales10,00010,00020,00020,00020,000
    Selling price per unit$     100$     100$      100$     100$     100
    Variable cost per unit6565656565
    Fixed costs300,000300,000300,000300,000300,000
    Pre-tax cash flow50,00050,000400,000400,000400,000

    The machine will be depreciated over 5 years on a straight-line basis for tax purposes and Lunar is subject to a 40% effective income tax rate. Assuming Lunar will have significant taxable income from other lines of business, and using a 20% discount rate, the net present value of the project would be

    • This topic was modified 1 week, 6 days ago by Lynn Roden. Reason: Corrected HTML in Visual view
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  • #232508
    Lynn Roden
    HOCK international

    Hello Charanpreet Kaur,

    Those are two different questions and they give different information. Every question stands on its own, and for each question you answer, you should use only the information given in that question. If you use information given in some other question, then you are answering that other question and not the question you are trying to answer.

    CMA 1295 4.12 does not give a tax rate, nor does it specify whether the cash flows given are before tax or after tax. Therefore, the only cash flow amounts available to use are the cash flow amounts given. So that is what you use to calculate the NPV.

    ICMA 10.P2.323 states that the cash flow amounts given are pre-tax and it gives the effective tax rate. Therefore, the cash flow amounts given are to be reduced by the income tax due on them before using them to calculate the NPV.

    Lynn

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