1

FM Written Assignment Unit #3

Determination of the Net Present Value

The net present value (NPV) method includes the time value of money and is a superior method

for long-term projects (Sinclair, 2010). The NPV method is a measure of financial value and one

approach to assessing the profitability of a proposed investment. The investment under

consideration WePROMOTE company is a single 5-year project that should be undertaken if it

has a positive NPV. The NPV is obtained by finding the difference between discounted cash

inflows and outflows (Jonick, 2017). The approach of finding NPV is depends on the values

given. In the instant case, the revenues and costs of the project are provided. Furthermore, the

method of depreciation, discounting rate and tax rate are also provided. Therefore, the NPV will

be determined as follows:

Step 1. Compute the annual cash inflows of the project. First the revenues are arranged per year

in columns, starting with year zero with zero expense. The column for year zero will include the

cost of the project which in this case is the initial outlay and an outflow. The cost/ expenses are

deducted to obtain the profit before depreciation and tax.

Annual cash flows = EBDT(1-T) + (Depreciation expense x T)

Where EBDT = earnings before depreciation and Tax i.e., Revenues- Expenses excluding

depreciation.

T= Tax Rate = 30%

Depreciation expense using straight line basis = cost/economic life

= $70000/5 = $14,000
2

The straight-line depreciation is one of the methods of depreciating assets adopted by businesses

(Jonick, 2017). The method requires an equal depreciation charged on the assets annually.

Usually, the formular for straight line depreciation is;

Depreciation Expense= (Cost of Assets- Salvage)/ Economic value.

However, in the case of the WeROMOTE project with no salvage value, the formular would be;

Depreciation expense = Cost/ economic life

Using the above formular, Annual cash inflows =

= (30000-11000)0.7 + (14000 x 0.3) = $17500.

Step 2. Determine the NPV by discounting the cash flows

NPV Calculation

Total/

Year 0 1 2 3 4 5 NPV

($70,000

Equipment cost )

Revenue $30,000 $30,000 $30,000 $30,000 $30,000

($11,000 ($11,000 ($11,000 ($11,000

Less costs ex. Depreciation ($11,000) ) ) ) )

Profit b4 tax and

depreciation $19,000 $19,000 $19,000 $19,000 $19,000

($14,000 ($14,000 ($14,000 ($14,000

less depreciation ($14,000) ) ) ) )

Profit before tax $5,000 $5,000 $5,000 $5,000 $5,000

Less tax @30% ($1,500) ($1,500) ($1,500) ($1,500) ($1,500)

3

Net Profit $3,500 $3,500 $3,500 $3,500 $3,500

Add back depreciation expense $14,000 $14,000 $14,000 $14,000 $14,000

($70,000

Annual Cash inflows ) $17,500 $17,500 $17,500 $17,500 $17,500

Discounting factor @6% 1 0.9434 0.8900 0.8396 0.7921 0.7473

($70,000

Present Value ) $16,509 $15,575 $14,693 $13,862 $13,077 $3,716

Verdict Accept the project since NPV is positive

Impact of Depreciation on the cash flows of a project

In the determination of annual cash flows, the expenses and depreciation are treated separately to

account for the depreciation tax shield benefit (Sarwary, 2019). The depreciation tax shield

benefit is the amount by which the tax expense reduces for a business being allowed to deduct

depreciation expense. The tax shield benefit = depreciation x tax rate.

Tax shield benefit = $14,000 x 30% =$4200

In the case, the deduction of depreciation expense leads to a tax saving of $4200 meaning that

the cash inflows will also increase by the same amount. Had the project not been adjusted for

depreciation, the annual cashflows of the project would be $13300.

Conclusion

The NPV technique result in one of the three outcomes;

i) The NPV value would be positive or greater than zero indicating that it monetary

value to the organization. In this case, NPV recommends the project to be undertaken.
4

ii) The NPV value may be equal to zero meaning that the project neither adds or

removes value from the organization. In such a case, the investors are said to be

indifferent about the project. The decision whether to accept or reject the project

should consider other monetary factors including availability of funds and alternative

investment projects

iii) Thirdly, the NPV value may be less than zero indicating that the investment does not

add value to the organization. The decision in this case is to reject the project.

In the case of WePROMOTE investment company, this analysis recommends the

undertaking of the new project since it has an NPV of $3716 dollars. The NPV means that

the project will add value to the company. Pursing the project will increase WePROMOTE

value by approximately $3716.

5

References

Jonick, C. (2017). Principles of financial accounting. Georgia: University of North Georgia

Press Dahlonega.

Sarwary, Z. (2019). Capital budgeting techniques in SMEs: A literature review. Journal of

Accounting and Finance. Retrieved from

https://articlegateway.com/index.php/JAF/article/view/2035

Sinclair, D. R. (2010). Capital budgeting decisions using the discounted cash flow method.

Canadian Journal of Anesthesia/Journal canadien d'anesthésie, 57, 704-705.