Bottoms Up Diaper Service is considering the purchase of a new industrial washer. It can purchase the washer for $7,200 and sell its old washer for $2,500. The new washer will last for 6 years and save $1,700 a year in expenses. The opportunity cost of capital is 15%, and the firm’s tax rate is 40%.

a. If the firm uses straight-line depreciation to an assumed salvage value of zero over a 6-year life, what is the annual operating cash flow of the project in years 0 to 6? The new washer will in fact have zero salvage value after 6 years, and the old washer is fully depreciated. (Negative amount should be indicated by a minus sign.)

b. What is project NPV? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to 2 decimal places.)

Explanation:

a.

Cost of new washer = $ 7,200

After tax sales value of old washer = $ 2,500 – ($ 2,500 x 0.4)

= $ 2,500 x 0.6 = $ 1,500

Initial investment = Cost of new washer - After tax sales value of old washer

= $ 7,200 - $ 1,500 = $ 5,700

Straight line annual depreciation of washer = Purchase cost/useful life

= $ 7,200/6 = $ 1,200

Annual operating cash flow = (Revenue as cost savings) x (1 – tax rate) + (tax rate x Depreciation)

= $ 1,700 x (1 – 0.4) + (0.4 x $ 1,200)

= $ 1,700 x 0.6 + 0.4 x $ 1,200

= $ 1,020 + $ 480 = $1,500

Cash flow in year 0 is - $ 5,700.

Annual operating cash flow of the project in year 1 through 6 is $ 1,500

b.

NPV = C x PVIFA (i, n) – initial investment  

C = Annual cash flow = $ 1,500

i = Rate of interest = 15 %

n = No. of periods = 6

NPV = $ 15,000 x PVIFA (15 %, 6) - $ 5,700

= $ 15,000 x 3.7845 - $ 5,700  = $ 5,676.75 - $ 5,700

= - $ 23.25

NPV of the project is - $ 23.25

answer; capital structure decision;