A company is considering the purchase of a new machine that will enable it to in

Question

A company is considering the purchase of a new machine that will enable it to increase its expected sales. The machine will have a price of $100,000. In addition, the machine must be installed and tested. The costs of installation and testing will amount to $40,000. The machine will be depreciated using 5-years MACRS. (Use MACRS table from class excel exercise)

The equipment will be operated for 6 years. The sales in the first year of operation are expected to be $200,000. Then, sales will grow by 5% per year until the sixth year. The annual operating costs (before depreciation) will consist of fixed operating costs of $25,000 plus variable operating costs equal to 75% of sales.

To support the increased level of production, the inventory of raw materials will have to be increased from $40,000 to $50,000 when the machine is purchased (remember that the relevant cash flow is the incremental). The additional inventory will be carried until the machine is scrapped following the 6 years of operation.

At the end of the 6-year operating life of the project, it is assumed that the equipment will be sold for $60,000.

The tax rate is 40% and the company

Explanation / Answer

New Machine Cost $100,000 Installation and Testing $40,000 Total Cost $140,000 Depriciation 5 years (MACRS) Life (Years) 6 Cost of Capital 9.50% Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Sales $200,000 $210,000 $220,500 $231,525 $243,101 $255,256 Operating Cost Fixed $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 Variable $150,000 $157,500 $165,375 $173,644 $182,326 $191,442 Total $175,000 $182,500 $190,375 $198,644 $207,326 $216,442 Depriciation $20,000 $32,000 $19,200 $11,486 $11,486 $5,760 Incremental Inventory $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 Total ($5,000) ($14,500) $925 $11,396 $14,290 $23,054 Savings from Tax $12,000 $19,200 $11,520 $6,891 $6,891 $3,456 Salvage Value $60,000 Net $7,000 $4,700 $12,445 $18,287 $21,181 $86,510 PVF 0.913 0.834 0.762 0.696 0.635 0.580 Value $6,393 $3,920 $9,479 $12,720 $13,455 $50,186 NPV $96,152 Since NPV is more than the cash outflow, Shall be accepted                             PI = Present Value of Future Cash Flows Initial Investment Required             0.69

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