Assume you are the owner and operator of a textile manufacturer. You must evalua

Question

Assume you are the owner and operator of a textile manufacturer. You must evaluate the proposal of buying a new machine for your factory. The company has already spent $5,000 investigating the feasibility of using the machine. The price of the equipment is $120,000. Shipping and installation will cost an additional $10,000. The machine falls under the MACRS 3-year class; the applicable depreciation rates are 33%, 45%, 15%, and 7%. After using the machine for three years it would be sold for $71,500. The machine would require an increase in net operating working capital of $6,000. The machine would not impact revenues, but it would cause pre-tax labor costs to decline by $42,500 per year. The marginal tax rate is 35% and the cost of capital is 11%.

a. How should the $5,000 spent on a feasibility analysis be handled?

b. What is the initial investment cost for the machine (Year 0 cash flow)?

c. What are the annual cash flows for years 1, 2 and 3?

d. Find the project’s NPV, IRR and MIRR.

e. Should you buy the machine? Explain your answer.

Explanation / Answer

a. How should the $5,000 spent on a feasibility analysis be handled? Ans) No, We already incurred the expenses. So, we not included the this amount in the investment cost. As, the amount you spent $5000 is a sunk cost. b. What is the initial investment cost for the machine (Year 0 cash flow)? Ans) The investment cost is $130,000. As, the price of the investment is 1,20,000 plus installation price of the $10,000. c. What are the annual cash flows for years 1, 2 and 3? Ans) Year Cost Cost Saving Less Depreciation Working Capital Net Profit Tax @ 35% Income after tax and depreciation Present value at 11% Present value of cash flow   Year-0 $       (130,000) $                (6,000) $                                                  (136,000) 1 $                                  (136,000) Year-1 $          42,500 $                  (42,900) $             (400) $                                                       42,500 0.901 $                                       38,288 Year-2 $          42,500 $                  (58,500) $       (16,000) $                                                       42,500 0.812 $                                       34,494 Year-3 $          42,500 $                  (19,500) $         23,000 $        8,050 $                                                       34,450 (23000-8050+19500) 0.731 $                                       25,190 Year-3 (Working capital release) $                   6,000 0.731 $                                         4,387 $                                     (33,641) d. Find the project’s NPV, IRR and MIRR. Ans) NPV = $       (33,641) IRR = 26% 33641/130000 e. Should you buy the machine? Explain your answer. Ans) No. As, the NPV is the negative

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