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NPV Problem A company is considering purchasing an asset for $70,000 that would have a useful life of 5 years and would have a salvage value of $3,500. For tax purposes, the entire original cost of the asset would be fully depreciated over 5 years using the straight-line method (book value would be zero when sold for its salvage value). The asset would generate annual net cash inflows of $32,000 throughout its useful life. The project would require additional working capital of $14,000, which would be released at the end of the project. The asset would require $19,000 in repairs in Year 4 to maintain its operability. The company's tax rate is 38% and its cost of capital is 13%. As an alternative, the company could invest $84,000 in tax-exempt bonds. It has the opportunity to purchase 130 bonds, 8%, 5-year bonds issued by Smallville, USA for $84,000. The maturity value of the bonds is $130,000 and interest payments of $5,200 will be paid semiannually for the next five years. Interest from municipal bonds is non-taxable. REQUIREMENTS 1 Determine the Net Present Value of each alternative. Alternative 1: Buy New Asset 13% Cost of Capital 35% Tax Rate ANNUAL Period n= 0 1 2 3 4 5 Initial Cost of New Asset Investment in Working Capital Pre-tax Annual Net Cash Inflows Depreciation Deductions Repairs in Year 4 Recovery of Working Capital Salvage Value New Pump METHOD #2 After-tax effect PVFactor (13%, n) Present value Alternative 2: Invest in Tax-Exempt Fixed-Rate 8% Bonds Purchase one-hundred-ten 5-year corporate bonds at a substantial discount, 8% annual interest paid semiannually 13% Cost of Capital SEMI-ANNUAL Period n= 0 1 2 3 4 Initial Investment Interest (8% interest paid semiannually) Bond maturity METHOD #2 After-tax effect PVFactor (6.5%, n) Present value 2 What is the dollar amount of total after-tax profits for each alternative over the five-year period? Alternative 1 Profit Alternative 2 Profit 3 Which alternative would you choose? Why? 5 6 7 8 9 10