# Question ID: CMA 695 4.5 (Topic: Net Present Value Method)

- This topic has 4 replies, 3 voices, and was last updated 9 months, 2 weeks ago by udayca1980.

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Question:

McLean Inc. is considering the purchase of a new machine that will cost $160,000. The machine has an estimated useful life of 3 years. Assume that 30% of the depreciable base will be depreciated in the first year, 40% in the second year, and 30% in the third year. The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40% estimated income tax rate and a 16% hurdle rate to evaluate capital projects.

Discount rates for a 16% rate are as follows:

Present Value of $1 Present Value of an

Ordinary Annuity of $1Year 1 0.862 0.862 Year 2 0.743 1.605 Year 3 0.641 2.246 What is the net present value of this project?

Answer suggested is as follows:

The cash flows are as follows:

Year 0 Year 1 Year 2 Year 3 Initial Investment (160,000) Depreciation 48,000 64,000 48,000 Depreciation Tax Shield (Depr. × 0.40) 19,200 25,600 19,200 Cash from disposition (after tax) 6,000 Operating cash flows 85,000 85,000 85,000 Tax on operating cash flow at 40% (34,000) (34,000) (34,000) Net Cash Flow 70,200 76,600 76,200 Discount factor: 16% 0.862 0.743 0.641 Discounted Cash Flow (160,000) 60,512 56,914 48,844 The net present value is $(160,000) + $60,512 + $56,914 + $48,844 = $6,270

Solution does not take into account the salvage value of $10k into account (line highlighted in red in above table). I feel that the solution should consider this impact. Could some one advise on this please.

Considering the salvage value in calculation of depreciation shield I get an NPV of $3,278.

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