Holmes Manufacturing is considering a new machine that costs $250,000 and would

Question

Holmes Manufacturing is considering a new machine that costs $250,000 and would reduce pre-tax manufacturing costs by $90,000 annually. Holmes would use the 3-year MACRS method to depreciate the machine, and management thinks the macine would have a value of $23,000 at the end of its 5-year operating life. The applicable depreciation rates are 33, 45, 15, and 7 percent as discussed in Appendix 12A. Working capital would increase by $25,000 intially, but it would be recovered at the end of the project's 5-year life. Holme's marginal tax rate is 40-percent, and a 10 percent WACC is appropriate for the project. Calcualte the project's IRR

Explanation / Answer

       0                1                2                3                4                5    

Initial investment    ($250,000)

Net oper. WC             (30,000)

Cost savings                                 $72,000   $ 72,000     $72,000     $72,000     $72,000

Depreciation                                 82,500   112,500     37,500     17,500                   0

Oper. inc. before taxes                ($10,500) ($ 40,500)    $34,500     $54,500     $72,000

Taxes (40%)                                  (4,200)   (16,200)    13,800     21,800     28,800

Oper. Inc. (AT)                           ($ 6,300) ($ 24,300)    $20,700     $32,700     $43,200

Add: Depreciationa                      82,500   112,500     37,500     17,500                   0

Oper. CF                                      $76,200   $ 88,200     $58,200     $50,200     $43,200

Return of NOWC                                                                                                $30,000

Sale of Machine                                                                                                     18,000

Tax on sale (40%)                                                                                                   (7,200)

Net cash flow         ($280,000)    $76,200   $ 88,200     $58,200     $50,200     $84,000

NPV = -$7,663.52

Base-case scenario:

This was worked out in part a. NPV = $37,035.13.

Best-case scenario:

                                         0                1                2                3                4                5    

Initial investment    ($250,000)

Net oper. WC             (20,000)

Cost savings                               $108,000   $108,000   $108,000   $108,000   $108,000

Depreciation                                 82,500   112,500      37,500      17,500                   0

Oper. inc. before taxes               $ 25,500 ($    4,500) $ 70,500   $ 90,500   $108,000

Taxes (40%)                                   10,200       (1,800)     28,200       36,200     43,200

Oper. Inc. (AT)                          $ 15,300 ($    2,700) $ 42,300   $ 54,300   $ 64,800

Add: Depreciationa                        82,500   112,500     37,500     17,500                   0

Oper. CF                                    $ 97,800   $109,800   $ 79,800   $ 71,800   $ 64,800

Return of NOWC                                                                                              $ 20,000

Sale of Machine                                                                                                     28,000

Tax on sale (40%)                                                                                                    (11,200)

Net cash flow         ($270,000) $ 97,800   $109,800   $ 79,800   $ 71,800   $101,600

NPV = $81,733.79

                              Prob.                     NPV           Prob.

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