4. The J.F. Manning Metal Co. is considering the purchase of a new milling machi

Question

4. The J.F. Manning Metal Co. is considering the purchase of a new milling machine during year 0. The machine's base price is $135,000, and it will cost another $15,000 to modify it for special use. This results in a $150,000 cost base for depreciation. The machine falls into the MACRS seven-year property class. The machine will be sold after three years for $80,000 (actual dollars). Use of the machine will require an increase in net working capital (inventory) of $10,000 at the beginning of the project year. The machine will have no effect on revenues, but it is expected to save the firm $80,000 (today's dollars) per year in before-tax operating costs, mainly for labor. The firm's marginal tax rate is 40%, and this rate is expected to remain unchanged over the duration of the project. However, the company expects that the labor cost will increase at an annual rate of 5%, but that the working capital requirement will grow at an annual rate of 8%, caused by inflation. The selling price of the milling machine is not affected by inflation. The general inflation rate is estimated to be 6% per year over the project period. The firm's market interest rate is 20%. a. Determine the project cash flows in actual dollars. b. Determine the project cash flows in constant (time-0) dollars. c. Is this project acceptable?

Explanation / Answer

Year 0 Year 1 Year 2 Year 3 Saving In operating costs (savings will decline by 5%every year) 0 80000 76000 72200 Depreciation -21435 -36735 -26235 58565 39265 45965 Tax on Above 23426 15706 18386 Add depreciation 21435 36735 26235 Cash flow from Saving of Operting Cost   and tax saving from depreciation 44861 52441 44621 Cost Of machine -150000 0 0 0 Working Capital Increase bt 8% -10000 800 1664 After tax Salvage value 48000 Working Capital 12464 Cash flow In actual Dollar Present Value of Cash flow -160000 45661 54105 105085 NPV @ 20% interest Rate Present Value of Cash flow ie time zero -23563 Depreciation rate 14.29% 24.49% 17.49% Base 150000 150000 150000 Depreciation 21435 36735 26235 No project is not acceptable since NPV is negative

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