Question

Evaluating cost-cutting proposal

We are considering automating some part of an existing production process. The necessary equipment cost $80,000 to buy and install. That automation will save $22,000 per year (before taxes) by reduing labor and material cost. For simplicity, assuming that the equipment has a five-year life and is depreciated to zero on a straight-line basis over that period. It will actually be worth $20,000 in fives years. Should we automate? The tax rate is 34 %, and the discount rate is 10 %.

Answer 1

1]	INITIAL INVESTMENT:
	Cost of the new machine	$         80,000
	Initial investment	$         80,000
2}	OPERATING CASH FLOWS:
	Annual savings in material & labor costs	$         22,000
	-Depreciation = 80000/5 =	$         16,000
	=NOI	$ 6,000
	-Tax at 34%	$ 2,040
	=NOPAT	$ 3,960
	+Depreciation	$         16,000
	=Annual OCF	$         19,960
3]	After tax salvage value = 20000*(1-34%) =	$         13,200
	Terminal non operating cash flow	$         13,200
4]	PV of annual OCF = 19960*(1.1^5-1)/(0.1*1.1^5) =	$         75,664
	PV terminal cash flow = 13200/1.1^5 =	$ 8,196
	PV of cash inflows	$         83,860
	Less: Initial investment	$         80,000
	NPV	$ 3,860
5]	As the NPV of the automation is positive, we
	should automate.