QUESTION 4. Connor’s Cuisine restaurant is considering buying a new dishwashing
ID: 2590882 • Letter: Q
Question
QUESTION 4.
Connor’s Cuisine restaurant is considering buying a new dishwashing machine. The machine would cost $60,000 today. When sold as scrap at the end of three years, the machine should generate $3,000 as scrap. Connor’s could continue hiring college students on a part time basis to wash dishes at an annual payroll cost of $22,000. The dishwasher would increase outflows for power and water, manual washing leads to great breakage. Considering all these costs, the dishwasher would save $2,000 in operating costs, If Connor’s purchases the machine, it would use the straight-line depreciation method.
Use the net present value method to determine whether Connor’s should purchase the dishwasher.
4-1. Connor, the owner, claims he puts all his money in his mattress and never goes near banks. So Connor’s opportunity cost of capital is a less lumpy mattress. Ignore taxes for now.
4-2. Connor meets an investment banker, Ms. Portwood, and now realizes there is more to consider. He now estimates his cost of capital is 10%. Ignore taxes here, too.
4-3. Connor meets a tax advisor, Ms. Caire and realizes that taxes ought to be considered as well. The tax rate on his business return is 40%.
Explanation / Answer
4-1 When cost of Capital is not given
Particulars
Year 1
Year 2
Year 3
Total
Annual Payroll cost saving
$22,000
$22,000
$22,000
$66,000
Cost Saving
$2,000
$2,000
$2,000
$6,000
Scrap Value
$3,000
$3,000
Total Cash Inflow
$24,000
$24,000
$27,000
$75,000
Intial Cash Outflow
$60,000
$60,000
Net Cash Inflow
$15,000
As it is a positive Cash inflow Connor's should purchase the dish washers
4-2 When Cost of Capital is 10%
Particulars
Year 1
Year 2
Year 3
Total
Annual Payroll cost saving
$22,000
$22,000
$22,000
$66,000
Cost Saving
$2,000
$2,000
$2,000
$6,000
Scrap Value
$3,000
$3,000
Total Cash Inflow
$24,000
$24,000
$27,000
$75,000
Discount Factor @10%
0.9091
0.8264
0.7513
Present Value of Cashflow
$21,818
$19,834
$20,285
$61,937
Intial Cash Outflow
$60,000
$60,000
Net Cash Inflow
$1,937
In this case also the NPV is positive, so Connor's should buy dishwasher
As Depreciation is a non cah item, it is not included in NPV calculation
4-3 When cost of capital is 10% and tax rate is 40%
Particulars
Year 1
Year 2
Year 3
Total
Annual Payroll cost saving
$22,000
$22,000
$22,000
$66,000
Cost Saving
$2,000
$2,000
$2,000
$6,000
Scrap Value
$3,000
$3,000
Total Cash Inflow
$24,000
$24,000
$27,000
$75,000
Less: Depreciation
$19,000
$19,000
$19,000
$57,000
Income befor taxes
$5,000
$5,000
$8,000
$18,000
Taxes @ 40%
$2,000
$2,000
$3,200
$7,200
After tax net income
$3,000
$3,000
$4,800
$10,800
Add: Depreciation
$19,000
$19,000
$19,000
$57,000
Afer tax net cash inflow
$22,000
$22,000
$23,800
$67,800
Discount Factor @10%
0.9091
0.8264
0.7513
Present Value of Cashflow
$20,000
$18,181
$17,881
$56,062
Intial Cash Outflow
$60,000
$60,000
Net Cash Inflow
($3,938)
Now in this case, NPV is negative, thus Connor's should not buy dishwasher
4-1 When cost of Capital is not given
Particulars
Year 1
Year 2
Year 3
Total
Annual Payroll cost saving
$22,000
$22,000
$22,000
$66,000
Cost Saving
$2,000
$2,000
$2,000
$6,000
Scrap Value
$3,000
$3,000
Total Cash Inflow
$24,000
$24,000
$27,000
$75,000
Intial Cash Outflow
$60,000
$60,000
Net Cash Inflow
$15,000
As it is a positive Cash inflow Connor's should purchase the dish washers
4-2 When Cost of Capital is 10%
Particulars
Year 1
Year 2
Year 3
Total
Annual Payroll cost saving
$22,000
$22,000
$22,000
$66,000
Cost Saving
$2,000
$2,000
$2,000
$6,000
Scrap Value
$3,000
$3,000
Total Cash Inflow
$24,000
$24,000
$27,000
$75,000
Discount Factor @10%
0.9091
0.8264
0.7513
Present Value of Cashflow
$21,818
$19,834
$20,285
$61,937
Intial Cash Outflow
$60,000
$60,000
Net Cash Inflow
$1,937
In this case also the NPV is positive, so Connor's should buy dishwasher
As Depreciation is a non cah item, it is not included in NPV calculation
4-3 When cost of capital is 10% and tax rate is 40%
Particulars
Year 1
Year 2
Year 3
Total
Annual Payroll cost saving
$22,000
$22,000
$22,000
$66,000
Cost Saving
$2,000
$2,000
$2,000
$6,000
Scrap Value
$3,000
$3,000
Total Cash Inflow
$24,000
$24,000
$27,000
$75,000
Less: Depreciation
$19,000
$19,000
$19,000
$57,000
Income befor taxes
$5,000
$5,000
$8,000
$18,000
Taxes @ 40%
$2,000
$2,000
$3,200
$7,200
After tax net income
$3,000
$3,000
$4,800
$10,800
Add: Depreciation
$19,000
$19,000
$19,000
$57,000
Afer tax net cash inflow
$22,000
$22,000
$23,800
$67,800
Discount Factor @10%
0.9091
0.8264
0.7513
Present Value of Cashflow
$20,000
$18,181
$17,881
$56,062
Intial Cash Outflow
$60,000
$60,000
Net Cash Inflow
($3,938)
Now in this case, NPV is negative, thus Connor's should not buy dishwasher
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