Chapter 13.C, Problem 5P

PROBLEM 13C-5 Income Taxes and Net Present Value Analysis L013-5, L013-8

Shimano Company has an opportunity to manufacture and sell one of two new products for a fiveyear period. The company’s tax rate is 30% and its after-tax cost of capital is 14%. The cost and revenue estimates for each product are as follows:

Product A Product B
Initial Investment in equipment…………….......................... $400,000 $550,000
Initial investment in working capital………………………... $85,000 $60,000
Annual sales …………………………………………………. $370,000 $390,000
Annual cash operating expenses…………………………….. $200,000 $170,000
Cost of repairs needed in three years………………………... $45,000 $70,000
The equipment pertaining to both products has a useful life of five years and no salvage value. The company uses the straight-line depreciation method for financial reporting and tax purposes. At the end of five years, each products ‘s working capital will be released for investment elsewhere within the company.

Required:

1. Calculate the annual income tax expense for each of years 1 through 5 that will arise if Product A is introduced.
2. Calculate the net present value of the investment opportunity pertaining to Product A.
3. Calculate the annual income tax expense for each of years 1 through 5 that will arise if Product B is intoduced.
4. Calculate the net present value of the investment opportunity pertaining to Product B.
5. Calculate the project profitability index for Product A and Product B. Which of the two products should the company purses? Why?