The Summitt Petroleum Corporation will purchase an asset that qualifies for three-year MACRS depreciation. The cost is $180,000 and the asset will provide the following stream of earnings before depreciation and taxes for the next four years:

The Summitt Petroleum Corporation will purchase an asset that qualifies for three-year MACRS depreciation. The cost is $180,000 and the asset will provide the following stream of earnings before depreciation and taxes for the next four years: Use Table 12-12.

 

Year 1	$	96,000
Year 2		110,000
Year 3		48,000
Year 4		46,000

 

The firm is in a 35 percent tax bracket and has a cost of capital of 12 percent. Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.

 

a.	Calculate the net present value. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places.)

 

Net present value

$

 

b.	Under the net present value method, should Summitt Petroleum Corporation purchase the asset?
	Yes

 
Explanation:

a.

First, determine annual depreciation.

Year	Depreciation Base		Percentage Depreciation (Table 12-12)			Annual Depreciation
1	$	180,000		.333		$	59,940
2		180,000		.445			80,100
3		180,000		.148			26,640
4		180,000		.074			13,320
						$	180,000

Then, determine the annual cash flow.

	Year 1			Year 2			Year 3			Year 4
EBDT	$	96,000		$	110,000		$	48,000		$	46,000
Depreciation		59,940			80,100			26,640			13,320
EBT	$	36,060		$	29,900		$	21,360		$	32,680
Taxes		12,621			10,465			7,476			11,438
EAT	$	23,439		$	19,435		$	13,884		$	21,242
Depreciation		59,940			80,100			26,640			13,320
Cash flow	$	83,379		$	99,535		$	40,524		$	34,562

Then, determine the net present value.

NPV	=	−$180,000 + ($83,379 / 1.12) + ($99,535 / 1.122) + ($40,524 / 1.123) + ($34,562 / 1.124)
	=	$24,603.19

b.

The asset should be purchased as the NPV is positive at the 12 percent cost of capital.

Calculator Solution:

Press the following keys: CF, 2nd, CLR WORK.

Calculator displays CF0, enter 180,000 +|−, press the Enter key.

Press down arrow, enter 83,379, and press Enter.

Press down arrow, enter 1, and press Enter.

Press down arrow, enter 99,535, and press Enter.

Press down arrow, enter 1, and press Enter.

Press down arrow, enter 40,524, and press Enter.

Press down arrow, enter 1, and press Enter.

Press down arrow, enter 34,562, and press Enter.

Press down arrow, enter 1, and press Enter.

Press NPV; calculator shows I = 0; enter 12 and press Enter.

Press down arrow; calculator shows NPV = 0.00.

Press CPT; calculator shows NPV = 24,603.19

Appendix Solution:

Year	Cash Flow (Inflows)	PVIF at 12%			Present Value
1	$ 83,379		.893		$	74,457.45
2	99,535		.797			79,329.40
3	40,524		.712			28,853.09
4	34,562		.636			21,981.43
	Present value of inflows				$	204,621.36
	Present value of outflows					180,000.00
	Net present value				$	24,621.36