Project Analysis – Capital Budgeting Techniques
Net Present Value Example
We are considering following project for investment purpose.
Initial cost of the project: $800,000
Project Life: 5 years
Annual Net Operation Profit: $280,000
Sales value of the project : $100,000 (at the end of the 5 years)
Annual allowable depreciation 15% of the project beginning value
Annual tax rate: 30%
After tax Cost of capital: 8%
Keeping in view the given information, we will decide whether we will undertake this investment or not. For this purpose we need to use some capital budgeting technique, and in this case we will use Net Present Value.
First, we will analyze the given information.
We have given Annual net operating profit generated by the project. During first four years, taxable income is the same as the net operating profit. To calculate taxable income for year 5, first we will add salvage value of the project i.e. $100,000 (Income generated through investing activities) to net operating profit generated during year 5. Then we will apply tax rate which is 30% to taxable income to get tax expense every year. After that we will subtract tax expense from taxable income to get Net Income.
Depreciation is considered as an expense and it reduces our net income hence some companies uses depreciation as a tax shield i.e. they will charge high percentage of depreciation and save themselves from taxes; therefore, in some cases the tax authorities set an upper limit on the percentage of depreciation …in this case we will consider the depreciation rate of tax authorities and we will deduct $100,000 salvage value from initial investment i.e. $800,000and charge depreciation on the remaining amount.
To find value of the Net Cash flows, we will add back depreciation expense to net income because depreciation expense is non-cash expense. We will calculate Present Value of Net Cash flows by using Cost of Capital (8%) and then add them to get PV of Net cash flows during five years. To calculate Net Present Value of the project, we will deduct Initial cost of the project from total PV of net cash flows. We can also use NPV calculator to calculate net present value of this project.
Solution:
NPV of the project is positive; therefore, we should invest in this project.