Running head: NPV CALCULATION WITH INCOME TAX 1

BUS111 Unit 3

NPV Calculation with Income Taxes for WePROMOTE Company

University Student

University of the People

NPV Calculation with Income Taxes for WePROMOTE Company

This case study will continue to follow on WePROMOTE Company’s new project

investment. WePROMOTE is a promotional business company that is planning to consider

manufacturing unique cases for smart phones as their new project. Qualitatively, this new project

will improve their product’s quality as their cases are durable and fits to all smartphone models.

To help the business owners if this project is worth considering, they need to use the NPV

approach to help them decide. According to AccountingCoach (2019) website, NPV is a good

decision-making tool for project investments. It is calculated by the sum of the present value

(calculated by using the company's cost of capital as the discount rate of cash inflows), minus the

present value of cash outflows, including the initial investment (PreMBA finance, n.d.; Lumen

Learning, n.d.).

Relevant cash flows of the company include:

1. Investment Cash Outflow: The initial investment for the new equipment installation of $105,000

is not adjusted for income taxes because it does not directly affect net income. This cost is

incurred prior to any cash is received by the project. Thus, this amount is included in full when

calculating the NPV with income taxes for the company.

2. Depreciation: As we all know that deprecation is never included in the cash outflow, however it

is indirectly included through tax income incentives. It serves as a tax shield reducing taxable

income and thereby reduces taxes that are paid. The equation for depreciation tax savings cash

inflow is:

Depreciation tax savings = Annual Depreciation expense × Tax rate.

Where: Depreciation expense is (Cost of the Asset-Salvage Value)/ Useful life of the asset.
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In this case study, the installation cost of the new equipment is $105,000 and has a useful

life of 5 years as well as a $5,000 salvage value. Using the straight-line method, the depreciation

expense is $20,000[=($105,000-$5,000) ÷ 5 years].The depreciation expense, $20,000, is

multiplied by the tax rate of 30% to get the annual depreciation tax savings of $6,000(=$20,000×

0.30).

3. Cash Outflows and Inflows: Estimated annual cash inflows (The gross revenues from the

project): $25,000 for year 1, $27,000 for years 2 and 3; $28,000 for year 4 and $23,000 for year 5

(last year of the project). While the estimated annual cash out flows (current project costs):

$13,000 for the first year; $12,000 for years 2, 3, and 4, $10,000 for the final year. Net cash

receipts is $71,000 ($130,000-$59,000). Total cash inflow includes the gross revenues and

salvage value, which is the estimated resale value of an asset at the end of its useful life

(AccountingTools, 2019). It must be noted that like the purchase price, salvage value also

represents one-time cash flow. (See Table 1 on page 5)

4. Revenues and Expenses: When a company must pay income taxes, all revenue cash inflows and

expense cash outflows affect net income and therefore affect income taxes paid. We need to

determine the after-tax cash flow since the tax income affects the net income of the company

thereby changing the cash flow. The key equation for finding this is:

after tax cash flow (receipt)= net cash receipts before taxes × (1 – tax rate)

where: net cash receipts is the total revenue minus the total cash outflow

After finding the after-tax cash flow, we will find the total cash flow in (out). The

equation is:

Total cash flow in(out)= After Tax Cash Flow + Annual depreciation savings
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For this case study, the tax rate for WePROMOTE is 30% and the total net cash receipts

(Year 1-5), revenue cash inflows minus expense cash outflows, is $76, 000= $135,000-$59,000.

Then, net cash receipts are multiplied by 0.70 (= 1 – 0.30). Thus, the total After Tax cash flow is

$53,200.

For annual net cash receipt,

Year 1: $12,000= $25,000-$13,000;

After tax cash flow (receipt) is $8,400= $12,000 × 0.70.

Total cash flow in (out) is $14,000= $8,400+$6,000.

(See table 1 for the succeeding calculations: year 2-5)

After identifying the significant lines of the company, we shall proceed in finding the

present values (PV). There are two ways in finding the PV: 1) by using the using the formula P =

Fn ÷ (1 + r)n ; and 2) by using the PV factor (See Figure 1 in the Appendix for the PV factor).

This paper will use the 2nd method: PV= Total Cash In (Out) × PV factor

Year 1: $14,400 × 0.9346 = $13,458

Year 2: $16,500 × 0.8734= $14,411

Year 3: $16,500 × 0.8163 = $13,469

Year 4: $17,200 × 0.7629 = $13,122

Year 5: $18,600 × 0.7130 = $13,262

Total Present Value is $67,721.97.

NPV is Investment cash outflow +total present value.

Therefore, NPV is -$37,278.03 or -$37,278 =-$105,000+$67,721.97

Where:
(a) Net Cash Receipts =total cash inflow-cash outflow
(b) After Tax Cash receipts= Net Cash Receipts × (1-tax rate)
(c) Annual depreciation tax savings= Depreciation expense × tax rate
(d) Total cash flow in(out)= After Tax Cash Flow + Annual depreciation savings

Although quantitative data for decision making is important, managers must be aware of the

qualitative factors. For this case, from a financial perspective, it is strongly recommended not

to pursue the project. The table above shows the estimated cash budget of the project. Within 5

years, the company will have NPV of -$37,278.03 or -$37,278. NPV rule states that if it has a

positive value, accept the project, otherwise if it presents negative, then reject it (Managerial

Accounting, 2012). It is clearly shown from the solution that the negative result will not add any

value to the company. They should re-evaluate the new project and come up with another

business proposal wherein there is an increase of gross revenue and they can procure a cheaper

cost for the new equipment. There is a great chance that under these conditions, the business

proposal will gain positive NPV, therefore adding value to the company.
NPV CALCULATION WITH INCOME TAX 6

References

AccountingCoach. (n.d.) What is NPV?. Retrieved September 15, 2019 from

https://www.accountingcoach.com/blog/npv-net-present-value

AccountingTools. (2019, January 06). Salvage value. Retrieved from

https://www.accountingtools.com/articles/what-is-salvage-value.html

AccountingTools. (2019, April 13). Present value of 1 table. Retrieved September 15,2019 from

https://www.accountingtools.com/articles/2017/5/17/present-value-of-1-table

Finance for Managers (2015). Licensed under a Creative Commons by-nc-sa 3.0

(http://creativecommons.org/licenses/by-nc-sa/ 3.0/.)

Lumen Learning. (n.d.). Net present value. Retrieved September 15, 2019 from

https://courses.lumenlearning.com/boundless-finance/chapter/net-present-value/

PreMBA finance. (n.d.). Evaluating cash flows: NPV & IRR. Retrieved September 20,2019 from

http://ci.columbia.edu/ci/premba_test/c0332/s5/s5_5.html

Managerial Accounting. (2012). Saylor Academy. Licensed by Creative Commons Attribution

NonCommercial-ShareAlike 3.0 License. Retrieved from

https://saylordotorg.github.io/text_managerial-accounting/s12-02-net-present-value.html
NPV CALCULATION WITH INCOME TAX 7

Figure

Figure 1: Present Value of 1 Table (AccountingTools, 2019)