Woodpecker Pipeline (WPP) is a contracting company that lays oil pipeline infrastructure. WPP is considering purchasing a piece of excavating equipment worth $5,000,000. The machine would generate a net $300,000 yearly pre-tax cash flows. The machine would be depreciated over the course of 20 years, at which time it is predicted to have a disposal value of $500,000. Management plans to depreciate full value of the asset (not deducting the anticipated disposal value in the calculation), and will take a full year of depreciation the first year. WPP's tax rate is 20%, and the discount rate is 11%.
What is the Excess Present Value Index of the proposed machinery (rounded to 4 decimal places)?

Question

Quizplus · Accepted Answer

Yearly Depreciation: $5,000,000 / 20 years = $250,000/year
Cash flow impact = Tax shield from depreciation: $250,000 × 0.20 = $50,000
After-tax Cash inflow: $300,000 × (1 - 0.20) = $240,000
Yearly after-tax cash flows: $240,000+ $50,000 = $290,000
PV of annuity: $290,000 × 7.96333 (20 years, 11%) = $2,309,365.70
Cash flow impact of disposal value (fully depreciated asset, all proceeds taxed as gain):
$500,000 × (1- 0.20) = $400,000
PV of disposal value: $400,000 × 0.12403 (20 years, 11%) = $49,612
Present Value of future cash flows: $2,309,365.70 + $49,612 = $2,358,977.70
Excess Present Value Index: $2,358,977.70/$5,000,000 = 0.4718

Woodpecker Pipeline (WPP) Is a Contracting Company That Lays Oil