Galveston Corporation is considering an investment in equipment for $45,000. Data related to the investment are as follows: Cash Flow before
Year Depreciation and Taxes 1 $30,000
2 30,000
3 30,000
4 30,000
5 30,000
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

Quizplus · Accepted Answer

To calculate the net present value, we need to first calculate the annual cash flows. Since there is no salvage value, the annual cash flows are simply the cash flow before depreciation and taxes minus depreciation expense, which is $30,000 - ($45,000/5) = $21,000 per year for five years. Then we calculate the present value of each annual cash flow using the formula:
PV = CF / (1 + r)^n
where CF is the annual cash flow, r is the cost of capital, and n is the number of years.

Year 1: PV = $21,000 / (1 + 0.18)^1 = $17,797.46
Year 2: PV = $21,000 / (1 + 0.18)^2 = $15,051.15
Year 3: PV = $21,000 / (1 + 0.18)^3 = $12,727.63
Year 4: PV = $21,000 / (1 + 0.18)^4 = $10,781.26
Year 5: PV = $21,000 / (1 + 0.18)^5 = $9,171.23

Then we sum the present values of all five years to get the net present value:
NPV = - initial investment + PV of cash flows
NPV = -$45,000 + $17,797.46 + $15,051.15 + $12,727.63 + $10,781.26 + $9,171.23
NPV = $2,528.73

Since the net present value is positive, the investment is expected to generate a return higher than the cost of capital, so Galveston Corporation should make the investment.

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