WePROMOTE Case Study
The Net present value (NPV) technique adds all cash inflows to a long-term investment and subtracts all cash outflows (Accounting Tools, 2022). Investments are allowed when the NPV exceeds or equals zero, according to Heisinger and Hoyle (n.d.); otherwise, the investment is rejected.
WePROMOTE Case Study
WePROMOTE is in the promotional materials business. The project being considered is to manufacture a unique case for smartphones. The case is very durable, attractive, and fits virtually all models of smartphones. It will also have the logo of your client, a prominent, local company, and is planned to be given away at public relations events by your client.
As we know from the prior case involving this company, more details of the project become apparent and with more precision and certainty.
The following are the final values to the data:
- The cost of the equipment will be $70,000 and this cost is incurred prior to any cash is received by the project.
- The expected annual cash revenue of the project will be $30,000.
- The expected annual cash outflows (expenses/costs) are estimated at being $11,000, excluding depreciation.
- Your tax rate is 30% and you plan to depreciate the equipment on a straight-line basis for the life of the equipment. The discount rate you are assuming is 6%.
- After 5 years the equipment will stop working and there will be no salvage value.
NPV Calculation
When evaluating assets, the net present value (NPV) method adds the present value of all cash inflows and subtracts the current value of all cash outflows. (Heisinger & Hoyle, n.d). There are three steps to calculating the NPV:
The NPV is calculated in three steps:
Step 1: Determine the amount and timing of the cash flows required during the life of the investment.
Step 2: Determine the interest rate, also known as the required rate of return, that will be used to evaluate the investment.
Step 3: Determine and assess the net present value of the investment (NPV).
Alternatively, we may compute the NPV in Excel by using the formula:
NPV = Investment cost multiplied by NPV(rate, value1, [value2],…)
Below is the formula for each value:
PV = Net cash flows / (1+ r)^ years
NPV = Sum of Present Value of Cash Inflows − Initial investment or cash outflows.
Calculation narrative:
- from the data provided we know equipment purchase price = $70,000 (no salvage value)
- Annual revenue = $30,000 and Annual expense = $11,000
- Net cashflows before tax = Revenue ($30,000) — Expenses ($11,000) = $19,000
- Depreciation can be calculated by dividing the equipment purchase price by 5 years period. Depreciation = $70,000/5 = $14,000
- Income (before tax) = Net cash inflow ($19,000) — Depreciation ($14,000) = $5,000
- Tax rate 30% = 0.3*Income before tax ($5,000) = $1,500
- Income (after tax) = Income (before tax) — Tax = $5,000 — $1,500 = $3,500
- Cashflows (after tax) = Income (before tax) + depreciation = $3,500 + $14,000 = $17,500
- Discounting factor can be calculated by: Discount rate = (1+ r)^ years
- Present Value = Cashflow (After Tax)*Discount rate
Income tax collected based on earnings has an impact on every capital investment. And these taxes have a negative impact on the company’s profitability and cash flow. As a result, any net present value estimate should take income tax into account in order to obtain an accurate NPV value (Obaidullah, 2014).
Depreciation is the loss of an asset’s value throughout its useful life. It is a non-monetary item, hence it has no effect on cash outflow in and of itself. However, it has an impact on the amount of taxes that a corporation must pay. This is due to the fact that depreciation charges are tax-deductible (Tuner, 2013).
While it has no effect on net income levels, it does have an effect on the amount of taxes paid since it works as a decrease when calculating net income. As a consequence, businesses benefit from a depreciation tax break and pay less tax. Companies must pay taxes on their net income, thus revenues (cash inflows) and expenditures (cash outflows) will have an impact on this. This is because these inflows and outflows have an impact on the net income or profits of the company (Heisinger & Hoyle, n.d). This resulting the depreciation can be calculated as linear depreciation = $70,000/5 years = $14,000/year as there is no salvage value.
Conclusion and Analysis
Based on the NPV calculation, WePROMOTE can take on this project since the NPV shows a positive value. A positive NPV shows that a project’s estimated earnings (cash inflow) surpass its anticipated costs (cash outflows). However, other elements must be considered, such as employee well-being, customer impression, competitiveness, and so on.
Furthermore, the NPV approach is predicated on assumptions about inflows and outflows. There may be a significant amount of cost that will only become apparent once the initiative is launched, and inflows may not always be as anticipated.
Companies must also be aware that depreciation and taxes will have a major influence on the net present value. Thus these elements must be given appropriate account when a net present analysis is being done. Overall, businesses have a highly dependable and precise approach in the NPV that gives data that are beneficial in making capital budgeting decisions.
References:
Accounting Tools. (2022, April 23). Present value definition — AccountingTools. AccountingTools. Retrieved September 22, 2022, from https://www.accountingtools.com/articles/present-value
Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html
Obaidullah, J. (2014, November 4). NPV and taxes. XPLAIND.com | Definitions, Explanations & Examples. Retrieved November 29, 2022, from https://xplaind.com/633736/npv-and-taxes
Tuner, J. A. (2013). Net Operating Working Capital Budgeting and Cash Budgets: A Teaching
Example. American Journal of Business, 6(6), 641–648.
Note:
This article is written based on University of The People Financial Management (BUS 5111) written assignment by Fristy Tania in November 2022
