A local day spa is considering investing in a machine that costs $60,000. The machine is expected to generate revenues of $25,000 per year for five years. The machine would be depreciated using the straight-line method with no half-year convention over its five year life and have no salvage value. The company considers the impact of income taxes in all of its capital investment decisions. The company has a 35 percent income tax rate and desires an after-tax rate of return of 14 percent on its investment. The net present value of the machine is:

Question

Quizplus · Accepted Answer

To calculate the net present value (NPV) of the investment, we need to calculate the present value of the expected cash flows from the machine and subtract the initial investment cost.

Annual cash inflows: $25,000
Initial investment: -$60,000
Depreciation expense: -$12,000 per year ($60,000/5 years)

To calculate the after-tax cash inflows, we need to subtract the income taxes on the cash inflows.

Annual before-tax cash inflows: $25,000
Income taxes (35%): -$8,750
Annual after-tax cash inflows: $16,250

To calculate the present value of the after-tax cash inflows, we need to use the after-tax rate of return of 14%.

NPV = -60,000 + [(16,250/1.14) + (16,250/1.14^2) + (16,250/1.14^3) + (16,250/1.14^4) + (16,250/1.14^5)]

NPV = -$49,793 + $60,000

NPV = $10,207

Therefore, the net present value of the machine is $10,207. As this is a positive NPV, it means that this investment would be profitable and the spa should go ahead with the investment to purchase the machine.

A Local Day Spa Is Considering Investing in a Machine