Madison Technologies is considering change in its method of delivery. In order t
ID: 2634515 • Letter: M
Question
Madison Technologies is considering change in its method of delivery. In order to do this, equipment would need to be purchased at a cost of $1,250,000 plus an additional $85,000 for shipping and installation. Madison believes that after 6 years, this equipment can be sold for $240,000. The company would need to increase its working capital by $150,000. The increase in revenue from this change is expected to be $600,000 per year with related operating costs of $320,000 per year and depreciation expense of $222,500 per year for 6 years. Madison is in the 30% tax bracket and its WACC is 9.5%.
1. What is the initial outlay for this project?
2. What are the annual recurring after-tax cash flows for this project?
3. What are the terminal cash flows for this project? Do not include Year 6 operating cash flows.
4. Should Madison change to the new delivery method? Why or why not?
Explanation / Answer
(1)
initial outlay = -cost of equipment - shipping and installation -working capital = - 1,250,000 - 85,000 - 150,000 = -1,485,000
(2)
annual recurring after-tax cash flows = (revenue - costs)*(1-tax rate) + depreciation*tax rate = (600,000 - 320,000)*(1 - 30%) + 222,500*30% = 262,750
(3)
BV of the equipment at year 6 = (1,250,000 + 85,000 )- 222,500*6 = 0
The equipment can be sold for $240,000 at year 6
thus, tax = (240,000 - 0)*30% = 72,000
aftertax salvage value of the equipment = 240,000 - 72,000 = 168,000
terminal cash flows = aftertax salvage value + working capital returned = 168,000 + 150,000 = 318,000
(4)
NPV of the project = -1,485,000 + 262,750*PVIFA(9.5%,6) + 318,000*PVIF(9.5%,6) = -1,485,000 + 262,750*(1-(1+9.5%)^(-6))/9.5% + 318,000*(1+9.5%)^(-6) = -139,213.81
As the NPV of the project is negative, Madison should not change to the new delivery method
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