A newly formed company is investigating the economic profitability of
purchasing equipment with an initial purchase price of $500,000
equipment.

The financial projection for this investment is as follows:
Installation, training of the personnel, and operating cost for the
first year is $70,000 but the company manages to sell enough products
from this equipment in the first year for $160,000.  The annual income
after year one is estimated to increases by $40,000 every year (the
years 2, 3,4?n). The operating cost of years 2, 3, 4?n is 40% of the
annual income.   The purchase cost of the equipment ($500,000) is
depreciated by straight-line method assuming a resale value of
$100,000 and a life of 5 years for depreciation purpose.  The
applicable interest rate is 10%, and the tax rate is 20%.

a-	If the equipment is sold at the book value at the end of the 5 th
year, what is the net present value of his project?
b-	If the equipment is sold at $140,000, at the end of the 5 th year,
what is the net present value of his project?
c-	If the equipment is sold at $50,000, at the end of the 5 th year,
what is the net present value of his project?

Kosa ?

As usual with these types of NPV calculations, a couple of assumptions
have to be made:
1.	the liquidation value is the only thing changed in year 5.  If a
finance manager KNEW that the equipment?s liquidation value were
changing, it would change the depreciation.  Judging liquidation
values is extremely difficult so these 3 different assumptions are
very realistic.

2.	though this project loses money in the first year, the company is
making money elsewhere ? otherwise it wouldn?t get the $800 tax return
shown in the spreadsheet that I?ve prepared for this problem.

3.	the final little ?trick? to this is that in C, if the equipment is
sold for $50,000, the firm is due $50,000 in additional depreciation.
We don?t want to overlook that, as it reduces taxes!

You can find a spreadsheet with all of the calculations here ? and
you?ll note that all of the NPVs are positive:
NPV Calculations
http://www.mooneyevents.com/kosa.xls

Some explanations of what is presented:
?	income is in black; loss or outflows of cash are in red
?	we use the ?year 0? convention to represent money going out now or
at the beginning of year 1

You have all 3 equipment scenarios here in different tables.  But in
all three we?ve done the income/tax calculations at the top.  Then we
add back Depreciation, which is a non-cash expense.  Depreciations
doesn?t use up cash ? in fact it is really there as an estimate of
equipment usage AND for tax purposes.

So, NPV of each scenario is:
A. $48,368
B. $73,205
C. $23,532

If there any part of this Google Answer is confusing, pleas request a
clarification before rating the answer.

Best regards,

Omnivorous-GA

Am studied accounting on my own and the treatment of non cash items
such as  depreciation in DCF analysis as has been done in this case
present a difficulty for me to understand. My understanding is that we
should ignore depreciation since DCF calculations are based on cash
inflows and outflows and not the accrual concept. Depreciation in my
view is not a cash flow. In any case the initial cost of the project
is a lump sum cash outflow at year. If we deduct depreciation from 
cash in flows are we not counting the lump sum amount twice?

On another note assuming this is correct, does it then follow that if
the resale value in (a) above was less than the book value, the
differential would then be written off as a cost hence reducing the
expected cash flows?