Detailed Answer
(c) The requirement is to calculate the net present value
of the investment. Answer (c) is correct. The net present value is
equal to the present value of the future after-tax cash flows minus
the initial investment. The after-tax annual cash flows are calculated
by taking the before-tax cash flows and deducting income
taxes. Since depreciation is deductible for tax purposes, annual
tax expense is equal to $15,000 [($140,000 – 90,000) × 30%].
Therefore, annual cash flows after taxes are $125,000 ($140,000
– 15,000). The present value of $125,000 received annually for 5
years discounted at 10% is $473,875 ($125,000 × 3.791). To
properly evaluate the project, the investment in working capital
($10,000) must be considered a part of the initial investment,
and its recovery at the end of year 5 must be discounted back to
its present value, along with the terminal value of the investment
of $50,000. The present value of $60,000 received at the end of 5
years is equal to $37,260 ($60,000 × .621). Therefore, the net
present value is equal to $1,135 ($473,875 + 37,260 – 500,000 –
10,000). Answer (a) is incorrect because it is the result when
amounts are not discounted. Answer (b) is incorrect because it is
the result when taxes are not considered.