Question

Raymobile Motors is considering the purchase of a new production machine for $500,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $150,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $25,000 after tax. In addition, it would cost $5,000 after tax to install this machine correctly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $30,000. This machine has an expected life of 10 years, after which it will have no salvage value. Assume simplified straight-line depreciation, that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 15 percent. 4 What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for Years 1 through 9? What is the terminal cash flow in Year 10(What is the annual after tax cash flow in Year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased? a. с.

Answer 1

a)Initial Outlay for the project is

Purchase cost of machinery................................. $ 500,000

Installation Cost after tax...................................... $ 5,000

Training Cost after tax.......................................... $ 25,000

Increase in Inventory(Initial net working capital)... $ 30,000

Total Initial Outlay...................................................$ 560,000

b) The annual after-tax cash flows associated with this project for years 1 through 9

Annual cash flow after tax =

Earning before interest & taxes (given) ................... $150,000 per year

Less: Tax @ 34%.......................................................$ 51,000 per year

Earning after tax.........................................................$ 99,000 per Year

Annual tax saving on Depreciation=

Total Purchase cost of machinery = Purchase cost + Installation Cost

Total Purchase cost of machinery = $ 500,000 + $ 5,000 = $ 505,000

Depreciation as per straight line method = (Purchase Price - Residual Value) / Useful Life of asset

Salvage or Residual Value = 0 (given) Useful Life = 10 Years (given)

Depreciation = ($ 505,000 - 0) / 10 = $ 50,500

Tax saving on depreciation per year = $ 50,500 * 34% = $ 17,170

Total annual after-tax cash flows for years 1 to 9= Annual cash flow after tax + Annual tax saving on Depreciation

Total annual after-tax cash flows for years 1 to 9 = $ 99,000 + $ 17,170 = $ 116,170

c) The terminal cash flow in year 10

The terminal cash flow in year 10 is the initial net working capital i.e. increase in Inventory = $ 30,000

So, the annual after-tax cash flow in year 10 plus additional cash flows associated with the termination of the project is

= $ 116,170 (from part b) + $ 30,000(terminal cash flow) = $ 146,170

d) Calculation of Net Present Value of the project to determine whether the project should be accepted or rejected.

If the NPV of project is positive it should be accepted and if it is negative the project should not be accepted.

Net Present Value of a project is calculated by reducing the present cash outflows from the present cash inflows.

Years	Cash Flows (a)	Discounting factor @ 15% (b)	Net Present Value (a * b)
0	(560,000.00)	1	(560,000.00)
1	116,170.00	0.869565217	101,017.39
2	116,170.00	0.756143667	87,841.21
3	116,170.00	0.657516232	76,383.66
4	116,170.00	0.571753246	66,420.57
5	116,170.00	0.497176735	57,757.02
6	116,170.00	0.432327596	50,223.50
7	116,170.00	0.37593704	43,672.61
8	116,170.00	0.326901774	37,976.18
9	116,170.00	0.284262412	33,022.76
10	146,170.00	0.247184706	36,130.99
Net Present Value			30,445.89

Note :Discounting factor is calculated using calculator as for year 1 = 1 / (1.15) , for year 2 = 1/ (1.15)2 , for Year 3 = 1/(1.15)3 and so on.

Since, the NPV of project is positive it is recommended that the machine should be purchased.