production line. The sprayer 2019s base price is $1,080,000, and it would cost a
ID: 2705641 • Letter: P
Question
production line. The sprayer 2019s base price is $1,080,000, and it would cost another
$22,500 to install it. The machine falls into the MACRS 3-year class, and it would be
sold after 3 years for $605,000. The MACRS rates for the first three years are 0.3333,
0.4445, and 0.1481. The machine would require an increase in net working capital
(inventory) of $15,500. The sprayer would not change revenues, but it is expected to
save the firm $380,000 per year in before-tax operating costs, mainly labor.
Campbell 2019s marginal tax rate is 35%.
a. What is the Year 0 net cash flow?
b. What are the net operating cash flows in Years 1, 2, and 3?
c. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of
working capital)?
d. Based on your IRR analysis, if the project%u2019s cost of capital is 12%, should the machine be purchased?
Show all calculations and formulas to get numbers!!!
Explanation / Answer
a. For Year 0, the cash flow is the cost of the machine, its installation, and the net working capital. Which is $1,118,000.
b. For Year 1-3, we must calculate the total change to our net income. Treat the cost savings of $380,000 per year like revenue. Then subtract the depreciation expense (the depreciation expense is the cost of the item, plus the installation multiplied by the MACRS rate), so that you can calculate the NOPAT (net operating profit after tax). This is found by taking the income from operations (that is, income before subtracting interest or tax exepense), and multiplying it by (1 - tax rate). To get the net cash flow, however, we must add back depreciation because it is not a cash expense. I have calculated all of these in the table below (look only half-way through to the cash flow from operations for part b, part c requires the additional information about the sale in year 3):
e. The IRR for this project is 14.43%, which is above the 12% required, so the machine should be purchased. I normally use a BAII PLus financial calculator or Microsoft Excel for financial calculations such as the IRR. I do not know of any way to calculate an IRR by hand without using a lot of guessing. I can tell you how to do it with either the calculator or Excel. If you really must calculate it by hand, I will tell you how, but it is very tedious.d. The third year is a little different. We are going to sell the equipment, and must take out the tax from the sale, and we also recover the net working capital investment, because we are not going to reinvest for the next year. The additional from the sale and recovery of net working capital is the total cash flow in year 3 minus the cash flow from operations: $711,732 - $302,982 = $408,750. Or you could add up the net working capital and sale price, minus the tax. Keep in mind that the net working capital is not taxed.
If you need further explanation on any point, please leave a comment.
Hope this helps!
Year 0 1 2 3 Revenue $ - $ 380,000 $ 380,000 $ 380,000 Depreciation $ - $ (367,463) $ (490,061) $ (163,280) Other Costs $ - $ - $ - $ - "NOPAT" $ - $ 8,149 $ (71,540) $ 140,868 Add Depreciation $ - $ 367,463 $ 490,061 $ 163,280 Cash Flow from Operations $ - $ 375,612 $ 418,521 $ 304,148 Cost of Machine $ (1,080,000) Installation $ (22,500) Net Working Capital $ (15,500) $ 15,500 Sale of Equipment $ 605,000 Book Value of Equipment $ 81,695 Profit from Sale $ 523,305 Tax on Sale $ (183,157) Total Cash Flow $ (1,118,000) $ 375,612 $ 418,521 $ 1,346,491Related Questions
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