The Doraville Machinery Company is planning to expand its current spindle produc

Question

The Doraville Machinery Company is planning to expand its current spindle product line. The required machinery would cost $500,000. The building that will house the new production facility would cost $1.5 million. The land would cost $250,000, and $150,000 working capital would be required. The product is expected to result in additional sales of $675,000 per year for 10 years, at which time the land can be sold for $500,000, the building for $700,000, and the equipment for $50,000. All of the working capital will be recovered. The annual disbursements for labor, materials, and all other expenses are estimated to be $425,000. The rm's income tax rate is 40%, and any capital gains will be taxed at 35%. The building will be depreciated with declining balance of depreciation rate of 20%. The manufacturing facility will be depreciated with declining balance with depreciation rate of 35%. The rm's MARR is known to be 15% after taxes. (a) Determine the projected net after-tax cash ows from this investment. Is the expansion justied?

(b) Compare the IRR of this project with that of a situation with no working capital.

Book Vaue

PW =

IRR=

Income Statement End of Year 0 1 2 3 4 5 Revenue Expenses Labor Material Overhead Depreciation Taxable income Income Tax Net Income Cash Flow Statement Operating Activities Net Income Depreciation Investment Activities Milling Machine Salvage Value Gain Tax Working Captial Financing Activities Borrowed funds Repayment of principle Net Cash Flow Purchase price End of Year Depreciation

Book Vaue

Annual revenue Annual sales Revenue per unit Unit variable cost labor material overhead Monthly volume Changes in working capital finished good inventory raw material inventory Accounts payable Accounts receivable TOTAL

PW =

IRR=

Explanation / Answer

Cost of machinery ($500,000) Cost of building ($1,500,000) Cost of land ($250,000) Working capital ($150,000) Total initial cash flow ($2,400,000) Additionalannual sales $675,000 Annual expenses ($425,000) Annual before tax income $250,000 Tax rate 40% Income tax ($100,000) Annual after tax income $150,000 Calculation of Deoreciation tax shield: BUILDING A B=A*0.2 C=A-B D=B*0.40 Beginning Depreciation Ending Depreciation Year Book Value Amount Book value Tax shield 1 $1,500,000 $300,000 $1,200,000 $120,000 2 $1,200,000 $240,000 $960,000 $96,000 3 $960,000 $192,000 $768,000 $76,800 4 $768,000 $68,000 $700,000 $27,200 MANUFACTURING FACILITIES A B=A*0.35 C=A-B D=B*0.40 Beginning Depreciation Ending Depreciation Year Book Value Amount Book value Tax shield 1 $500,000 $175,000 $325,000 $70,000 2 $325,000 $113,750 $211,250 $45,500 3 $211,250 $73,938 $137,313 $29,575 4 $137,313 $48,059 $89,253 $19,224 5 $89,253 $39,253 $50,000 $15,701 Before tax Terminal cash flow: Land $500,000 Building $700,000 Equipment $50,000 Working capital release $150,000 After tax cash flow of land: Capital gain=(500000-250000) $250,000 Capital gain Tax(35%) $87,500 A After tax cash flow of land: $162,500 B After tax cash flow of Building $700,000 C After tax cash flow of machinery $50,000 D Working capital release $150,000 E=A+B+C+D Total terminal Cash flow $1,062,500 Present value(PV) of cash flow=(Cash flow)/((1+i)^N) i=discount rate=MARR=15%=0.15 N=Year of cash flow Year wise Casflows and PV of cash flows are given below A B C D E F=A+B+C+D+E G=F/(1.15^N) Initial Annual Depreciation Depreciation Terminal Net PV of YEAR Cash flow After tax Tax shield Tax shield Cash flow Cash flow Net Cashflow 0 ($2,400,000) Cash flow Building Equipment $0 ($2,400,000) -2400000 1 $0 $150,000 $120,000 $70,000 $0 $340,000 295652.1739 2 $0 $150,000 $96,000 $45,500 $0 $291,500 220415.879 3 $0 $150,000 $76,800 $29,575 $0 $256,375 168570.7241 4 $0 $150,000 $27,200 $19,224 $0 $196,424 112305.9166 5 $0 $150,000 $0 $15,701 $0 $165,701 82382.78165 6 $0 $150,000 $0 $0 $0 $150,000 64849.13939 7 $0 $150,000 $0 $0 $0 $150,000 56390.55599 8 $0 $150,000 $0 $0 $0 $150,000 49035.26608 9 $0 $150,000 $0 $0 $0 $150,000 42639.36181 10 $0 $150,000 $0 $0 $1,062,500 $1,212,500 299711.4562 TOTAL -1008046.745 PROJECTED CASH FLOWS: Year Cash Flow PV of cash flow 0 ($2,400,000) -2400000 1 $340,000 295652.1739 2 $291,500 220415.879 3 $256,375 168570.7241 4 $196,424 112305.9166 5 $165,701 82382.78165 6 $150,000 64849.13939 7 $150,000 56390.55599 8 $150,000 49035.26608 9 $150,000 42639.36181 10 $1,212,500 299711.4562 TOTAL -1008046.75 NPV= $(1,008,047) Internal rate of return =IRR (using IRR function of excel) 3.96% The expansion is not justified IRR is less than MARR NPV is negative If there is no working capital Initial cash flow ($2,250,000) Terminal cash flow $1,062,500 Year wise cash flow year 0 ($2,250,000) 1 $340,000 2 $291,500 3 $256,375 4 $196,424 5 $165,701 6 $150,000 7 $150,000 8 $150,000 9 $150,000 10 $1,062,500 IRR= 4.34%

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