Galveston Corporation is considering an investment in equipment for $45,000. Data related to the investment are as follows: Cost of capital is 18 percent.
Galveston uses the straight-line method of depreciation with no mid-year convention. In addition, their tax rate is 40 percent, and the life of the equipment is five years with no salvage value.
What is the net present value of the investment?

Question

Galveston Corporation is considering an investment in equipment for $45,000. Data related to the investment are as follows:  Cost of capital is 18 percent.
Galveston uses the straight-line method of depreciation with no mid-year convention. In addition, their tax rate is 40 percent, and the life of the equipment is five years with no salvage value.
What is the net present value of the investment?

Quizplus · Accepted Answer

To calculate the net present value (NPV) of the investment, we need to determine the cash inflows and outflows associated with the equipment.

The initial investment of $45,000 is a cash outflow in year 0.

To calculate the annual cash inflows, we need to determine the annual depreciation expense. Since the equipment has a life of 5 years with no salvage value, the annual depreciation expense is $9,000 ($45,000/5).

Since Galveston has a tax rate of 40 percent, the annual tax savings due to the depreciation expense are $3,600 (0.4 x $9,000).

The annual cash inflows are calculated as follows:

Year 1: $3,600
Year 2: $3,600
Year 3: $3,600
Year 4: $3,600
Year 5: $3,600

To calculate the NPV, we discount the cash inflows and outflows by the cost of capital of 18 percent. Using a financial calculator or Excel, we get an NPV of $22,543.

Since the NPV is positive, the investment is expected to earn a return higher than the cost of capital, and thus, it is a good investment for Galveston Corporation.

Galveston Corporation Is Considering an Investment in Equipment for $45,000