Purple Haze Machine Shop is considering a four-year project to improve its produ

Question

Purple Haze Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $460,000 is estimated to result in $185,000 in annual pretax cost savings. The press falls in the MACRS five-year class, and it will have a salvage value at the end of the project of $78,000. The press also requires an initial investment in spare parts inventory of $19,000, along with an additional $2,400 in inventory for each succeeding year of the project. The shop

Purple Haze Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $460,000 is estimated to result in $185,000 in annual pretax cost savings. The press falls in the MACRS five-year class, and it will have a salvage value at the end of the project of $78,000. The press also requires an initial investment in spare parts inventory of $19,000, along with an additional $2,400 in inventory for each succeeding year of the project. The shop

Explanation / Answer

First, we will calculate the depreciation each year, which will be:

                D1 = $460,000*(0.2000) = $92,000

                D2 = $460,000*(0.3200) = $147200

                D3 = $460,000*(0.1920) = $88320

                D4 = $460,000*(0.1152) = $52992

The book value of the equipment at the end of the project is:

BV4 = $460000-(92000+147200+88320+52992) = $79488

The asset is sold at a loss to book value, so this creates a tax refund.

After-tax salvage value = $78000+(79488-78000)(0.34) = $78505.92

OCF1 = $185000(1-34%)+0.34(92000) = $153380

OCF2 = $185000(1-34%)+0.34(147200) = $172148

OCF3 = $185000(1-34%)+0.34(88320) = $152128.80

OCF4 = $185000(1-34%)+0.34(52992) = $140117.28

We need to be careful with the NWC in this project. Notice the project requires $19,000 of NWC at the beginning, and $2400 more in NWC each successive year.

We will subtract the $19,000 from the initial cash flow, and subtract $2400 each year from the OCF to account for this spending.

In Year 4, we will add back the total spent on NWC, which is $26200

NPV:

hence, $78253.15 is the NPV

Year Cashflows Present value 0 -479000 -479000 1 150980 137254.55 2 169748 140287.60 3 149728.8 112493.46 4 244823.2 167217.54 NPV 78253.15

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