Question

3- Raphael Restaurant is considering the purchase of a $12,000 soufflé maker. The soufflé maker has an economic life of five years and will be fully depreciated by the straight line method. The machine will produce 1,900 soufflés per year, with each costing $2.20 to make and priced at $5. Assume that the discount rate is 14 percent and the tax rate is 34 percent. Should Raphael make the purchase?

Answer 1

Time line		0	1	2	3	4	5
Cost of new machine		-12000
=Initial Investment outlay		-12000
								100.00%
Unit sales			1900	1900	1900	1900	1900
Profits	=no. of units sold * (sales price - variable cost)		5320	5320	5320	5320	5320
-Depreciation	Cost of equipment/no. of years		-2400	-2400	-2400	-2400	-2400	0	=Salvage Value
=Pretax cash flows			2920	2920	2920	2920	2920
-taxes	=(Pretax cash flows)*(1-tax)		1927.2	1927.2	1927.2	1927.2	1927.2
+Depreciation			2400	2400	2400	2400	2400
=after tax operating cash flow			4327.20	4327.20	4327.2	4327.2	4327.2
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							0
Total Cash flow for the period		-12000	4327.2	4327.2	4327.2	4327.2	4327.2
Discount factor=	(1+discount rate)^corresponding period	1	1.14	1.2996	1.481544	1.6889602	1.9254146
Discounted CF=	Cashflow/discount factor	-12000	3795.7895	3329.6399	2920.7367	2562.0498	2247.4121
NPV=	Sum of discounted CF=	2855.63

Accept machine as nPV is positive