Winthrop Company has an opportunity to manufacture and sell a new product for a five-year period. To pursue this opportunity, the company would need to purchase a piece of equipment for $165,000.

Winthrop Company has an opportunity to manufacture and sell a new product for a five-year period. To pursue this opportunity, the company would need to purchase a piece of equipment for $165,000. The equipment would have a useful life of five years and zero salvage value. It would be depreciated for financial reporting and tax purposes using the straight-line method. After careful study, Winthrop estimated the following annual costs and revenues for the new product:

Annual revenues and costs:
Sales revenues	$	320,000
Variable expenses	$	155,000
Fixed out-of-pocket operating costs	$	77,000

The company’s tax rate is 30% and its after-tax cost of capital is 14%.

Required:

1. Calculate the annual income tax expense that will arise as a result of this investment.

2. Calculate the net present value of this investment opportunity. (Round your final answer to nearest whole dollar.)

Explanation

1.

The annual income tax expense is computed as follows:

	Years 1-5
Annual tax expense:
Sales	$	320,000
Variable expenses		(155,000	)
Out-of-pocket costs		(77,000	)
Depreciation expense ($165,000 ÷ 5)		(33,000	)
Incremental net income	$	55,000
Tax rate		30	%
Income tax expense	$	(16,500	)

2.

The net present value is computed as follows:

	Now				Years 1-5
Net present value:
Purchase equipment	$	(165,000	)
Sales					$	320,000
Variable expenses						(155,000	)
Out-of-pocket costs						(77,000	)
Income tax expense						(16,500	)
Total cash flows (a)	$	(165,000	)		$	71,500
Discount factor (b)		1.000				3.432
Present value (a) × (b)	$	(165,000	)		$	245,388
Net present value	$	80,390

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