This answer results from an incorrect calculation of the net after-tax cash flow from the sale of the equipment at the beginning of Year 6 (which is the same as the end of Year 5) when its book value is zero. The after-tax cash flow from the sale of the equipment is calculated as $50,000 multiplied by the tax rate of 40%. That is the amount of income tax that will be due on the gain. It is not the net after-tax cash flow from the sale of the equipment. The after-tax cash flow from the sale of the equipment is the cash received minus the amount of income tax that will be due on the gain.
This answer results from using the full $50,000 to be received from the sale of the equipment as the cash flow when it is sold. There will be tax to be paid on the gain from the sale, and since the equipment's book value will be zero, the full $50,000 to be received will be taxable as a gain. Therefore, the net cash received from the sale will be less than $50,000.
This answer results from omitting the projected cash flow from the sale of the equipment at the beginning of Year 6.
In capital budgeting, we assume that all cash flows take place at the end of each year. Since the machine will be sold at the beginning of Year 6, we need to include the cash flow from the sale of the machine with the end of Year 5 cash flows. That makes the Year 5 after-tax cash flow $350,000 + ($50,000 × .60), or $380,000. Now, all that is needed is to discount the after-tax cash flows that are given in the problem. After-Tax PV of $1 Discounted Year Cash Flow Factor @ 14% Cash Flow 0 $(550,000) 1.000 $(550,000) 1 (500,000) .877 (438,500) 2 450,000 .769 346,050 3 350,000 .675 236,250 4 350,000 .592 207,200 5 380,000 .519 197,220 NPV $( 1,780)
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Management anticipates the equipment will be sold at the beginning of year 6 for $50,000 when its book value is zero. Smithco's internal hurdle and effective tax rates are 14% and 40%, respectively. The project's net present value would be