1.Your firm is considering a project that would require purchasing $7.5 million worth of new equipment. Determine the present value of the depreciation tax shield associated with this equipment if the firm’s tax rate is 40%, the appropriate cost of capital is 8%, and the equipment can be depreciated
a. Straight-line over a 10-year period, with the first deduction starting in one year.
b. Straight-line over a five-year period, with the first deduction starting in one year.
c. Using MACRS depreciation with a five-year recovery period and starting immediately.
d. Fully as an immediate deduction.
2.Arnold Inc. is considering a proposal to manufacture high-end protein bars used as food supplements by body builders. The project requires use of an existing warehouse, which the firm acquired three years ago for $1m and which it currently rents out for $120,000. Rental rates are not expected to change going forward. In addition to using the warehouse, the project requires an up-front investment into machines and other equipment of $1.4m. This investment can be fully depreciated straight-line over the next 10 years for tax purposes. However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $500,000. Finally, the project requires an initial investment into net working capital equal to 10% of predicted first-year sales. Subsequently, net working capital is 10% of the predicted sales over the following year. Sales of protein bars are expected to be $4.8m in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses (excluding depreciation) are 80% of sales, and profits are taxed at 30%.
a. What are the free cash flows of the project?
b. If the cost of capital is 15%, what is the NPV of the project?