Question

Read Book Company is the manufacturer of exercise machines and is considering producing a new line of equipment in an effort to increase its market share.
The new production line will cost $850,000 for manufacturing the parts and an additional $280,000 is needed for installation.
The equipment falls into the MACRS 3-yr class, and would be sold after four years for $350,000. The equipment line will generate additional annual revenues of $600,000, and will have additional annual operating expenses of $300,000. An inventory investment of $75,000 is required during the life of the project. Read Book Company is in the 25 percent tax bracket, and its existing cost of capital is 8 percent.
a. Calculate the initial outlay of the project
b. Calculate the annual after-tax operating cash flow for Years 1 -4.
c. Determine the terminal year non-operating cash flow in year 4:
d. What is the equipment NPV?
e. What is the estimated Internal Rate of Return (IRR) of the equipment?
f. Should the equipment be accepted based on the IRR criterion?

Answer 1

Please find the solution in given screen shots,

Amount in $

(a) Initial Outlay of the Project cost Add: Installation Cost Initial Outlay 850,000 280,000 1,130,000 (b) Annual After Tax Operating Cash Flow Additional Revenue Less: Additional Operating Expense Less: Depreciation EBIT Less: Tax @25% EAT Add: Depreciation Annual Operating Cash flow Year 1 600,000 300,000 376,629 -76,629 -19,157 -57,472 376,6291 319,157 Year 2 600,000 300,000 502,285 -202,285 -50,571 -151,714 502,285 350,571 Year 3 600,000 300,000 167,353 132,647) 33,162 99,485 167,353 266,838 Year 4 600,000 300,000 83,733 Refer WN-1 216,267 54,067 162,200 83,733 245,933 (c) Terminal Year Non Operating Cash Flow From Sale of Equipment - (Salvage) Add: Recovery of Working Capital - (Inventory) Non Operating Cash flow Year 4 262500 Refer WN-2 75000 337500

(d) Equipment NPV Year Year 1 Year 2 Year 3 Year 4 NPV Initial Outlay -1,130,000 Investment in Inventory -75,000 Cash from Operation 319,157 350,571 266,838 245,933 Refer Solution (a) Cash from Sale of Equipment 262,500 Refer WN-2 Recovery of Investment from Inventory 75,000 Net Cash flow -1,205,000 319,157 3 50,571 266,838 583,433 Discounting Factor @ 8% 11 0.92592593 0.857338821 0.79383224 0.73502985 Refer WN-3 Net Discounted Cash flow - 1205000 295515.972 300558.342 211824.806 428840.856 31739.976 (Net Discounted Cash flow = Net Cash Flow X Discounting Factor) WN-1 Calculation of Depreciation Initial Outlay Depreciation Method Depreciable Value 1,130,000 MACRS 3 Year Class 1,130,000 No Salvage is considered when MACRS is used ACRS | Year 1 Year 2 Depreciation Rate as per MACRS-3 Years Class 33.33% 44.45% Depreciation - $ 376,629 502,285 Book Value at Year End 753,371 251,086 (Book Value at Year End = Book Value at the end of previous Year minus Yearly Depreciation) Year 3 14.81% 167,353 83,733 Year 4 7.41% 83,733 WN-2 Book Value of Equipment at Year 4 Sale Proceed Gain on Sale of Equipment - Sale Proceed minus Book Value) Less: Tax on Gain @25% Net of Tax Cash from Sale of Asset 0 Refer WN-1 350,000 350,000 87,500 262,500

WN-3 Discounting Factor @ 8% Discounting Factor = 1/(1+r)^n where, r = rate of interest and n = number of year