A pharmaceutical company may buy DNA testing equipment costing
$60,000.  This equipment is expected to reduce clinical staff labor
costs by $20,000 annually.  The equipment has a useful life of 5
years, but falls in the 3-year prperty class for cost recovery
(depreciation) purposes.  No salvage value is expected at the end. 
The corporate tax rate for the company is 38 percent, and its required
rate of return is 15 percent.  (If profits before taxes on the project
are negative in any year, the firm will recieve a tax credit of 38
percent of the loss in that year.)  On the basis of this information,
what is the net present value of the project?  Is it acceptable?

   Now suppose 6 percent inflation in labor cost savings is expected
over the last 4 years, so that savings in the first year are $20,000,
savings in the second year are $21,200, and so fourth.

If the required rate of return is still 15 percent, what is the net
present value of the project?  Is it acceptable?

If the working capital requirement of $10,000 were required in
addition to the cost of the equipment and this additional investment
were needed over the life of the project, what would be the effect on
net present value? (All other things are the same as in the previous
question.)

Scenario 1:

In Year 0, there is a negative cash flow of $60,000 to purchase
equipment.  The labor savings is $20,000 per year in Years 1-5. 
Assuming straight-line depreciation over three years, and using the
corporate tax rate of 38%, a tax credit of $7,600 per year is
generated in Years 1-3.

Therefore, Year 0 has a cash flow of -$60,000, Years 1-3 have cash
flows of $27,600 per year, and Years 4-5 have cash flows of $20,000
per year.

Net present value is calculated by the formula: cash flow (period
n)/(1 + interest rate) ^ period  n.

Using the interest rate of 15% and the net present value formula, I
calculate a net present value of $24,395.61.  Because the net present
value is positive, the project is acceptable.

Scenario 2:

The purchase expense and tax credit remain the same, but the labor
savings increase at a rate of 6% per year during years 2-5.

Therefore, Year 0 has a cash flow of -$60,000, Year 1 has a cash flow
of $27,600, Year 2 has a cash flow of $28,800, Year 3 has a cash flow
of $30,072, Year 4 has a cash flow of $23,820.32, and Year 5 has a
cash flow of $25,249.54.

Using the interest rate of 15% and the net present value formula, I
calculate a net present value of $31,722.59.  Because the net present
value is positive, the project is acceptable.  Moreover, the increased
labor costs savings have rendered the project more attractive.

Scenario 3:

Everything remains the same from Scenario 2, except for the addition
of a working capital requirement of $10,000.  The working capital
requirement increases the negative cash flow in Year 0 by $10,000, and
increases the positive cash flow in Year 5 by $10,000 (once the
project is over, the working capital is recovered).

Therefore, Year 0 has a cash flow of -$70,000, Year 1 has a cash flow
of $27,600, Year 2 has a cash flow of $28,800, Year 3 has a cash flow
of $30,072, Year 4 has a cash flow of $23,820.32, and Year 5 has a
cash flow of $35,249.54.

Using the interest rate of 15% and the net present value formula, I
calculate a net present value of $26,694.36.  Because the net present
value is positive, the project is acceptable.  However, the working
capital requirement has rendered the project less attractive than
before.

Sincerely,

Wonko

Source: "Principles of Engineering Economy" Eighth Edition by Grant,
Ireson, and Leavenworth, John Wiley & Sons, 1990.