Verla Industries is trying to decide which one of the following two options to p

Question

Verla Industries is trying to decide which one of the following two options to pursue. Either option will take effect on January 1st of the next year. Option One -- Acquire a New Finishing Machine The cost of the machine is $1,000,000, and it will have a useful life of 5 years. Net pre-tax cash flows arising from savings in labor costs will amount to $100,000 per year for 5 years. Depreciation expense will be calculated using the straight-line method for both financial and tax reporting purposes. As an incentive to purchase, Verla will receive a trade-in allowance of $50,000 on its current fully depreciated finishing machine. Option Two -- Outsource the Finishing Work Verla can outsource the work to LM, Inc., at a cost of $200,000 per year for 5 years. If it outsources, Verla will scrap its current fully depreciated finishing machine. Verla’s effective income tax rate is 40%. The weighted-average cost of capital is 10%. The firm’s net present value of acquiring the new finishing machine is A. $229,710 net cash outflow. B. $267,620 net cash outflow. C. $369,260 net cash outflow. D. $434,424 net cash outflow.

Explanation / Answer

NEW MACHINE: INITIAL INVESTMENT: Cost of the new machine after trade in allowance 950000 ANNUAL OPERATING CASH FLOWS: Savings in cost net of tax = 100000*0.60 = 60000 Depreciation tax shield = (950000/5)*40% = 76000 Total annual after tax cash inflows 136000 PV of annual cash flows = 136000*(1.1^5-1)/(0.1*1.1^5) = 515547 Initial investment 950000 NPV -434453 Answer: Option D: $434,424 (marginally different from the above solution)

Related Questions

Navigate

• Browse (All)
• Browse V
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.