You are evaluating a proposal to buy a new machine. The base price is $108,000,

Question

You are evaluating a proposal to buy a new machine. The base price is $108,000, and shipping and installation costs would add another $12,500. The machine is depreciated using prime cost method (3 years useful life), and it would be sold after 3 years for $60,000. The machine would require a $5,500 increase in net operating working capital (in year 0) and this will be returned at the end of year 3. The pre-tax labour costs would decline by $44,000 per year. The marginal tax rate is 35% and the WACC is 12%.

1) What are the project’s annual cash flows during years 0, 1, 2 and 3? (12 marks)

2) Calculate NPV (6 marks) and advise whether this project should be accepted based on its NPV (2 marks).

Explanation / Answer

The prime cost method assumes that the value of a depreciating asset decreases uniformly over its effective life.Under the prime cost method (also known as the straight line method), you claim a fixed amount each year based on the following formula:

Asset’s cost × (days held/365) × (100%/asset’s effective life)

The salvage value is $60,000 after three years

The costof asset is base price + shipping and installation costs amounting to $120,500 ( $108,000+$12,500)

The life of asset is 3 years

The depreciation per year would be

Depreciation per year = asset cost x days held /365 x 100%/asset effective life

Where

Asset cost = cost of asset – salvage value

Asset cost = $120,500 - $60,000

Asset cost = $60,500

Asset effective life = 3

Depreciation per year = $60,500 x (365/365) x (100%/3)

Depreciation per year = $60,500 x 1 x 1/3

Depreciation per year =$20166.67

The tax rate is given is 35%

The annual savings in pre tax labor cost is $44,000

The cost of capital is 12%

The net working capital required is at year 0 is $5,500

This working capital is recovered at the end of year 3 is $5,500

Find below the calculation of cash inflow and NPV on the above details given

1) the cash flows from year 0 to 3 is given below , to note the working capital is a cost in year 0 and revenue in tear 3

2) the NPV is $4,897 means the cash inflows are more the cash outflows hence the project is accepted on positive NPV

NPV calculation year equipment cost cash inflow Depreciation as per prime cost working capital savings before tax tax @.35 savings after tax add -: deprecition annual cash inflow pV factor @12% cash inflow at present value 0     (120,500)        (5,500) (126,000)     (126,000)     (126,000) 1      (126,000) 1 $44,000 20166.67 $23,833      8,341.67    15,491.66    20,166.67    35,658.33    0.89286    31,837.80 2 $44,000 20166.67 $23,833      8,341.67    15,491.66    20,166.67    35,658.33    0.79719    28,426.61 3 $44,000 20166.67           5,500 $29,333 10,266.67    19,066.66    20,166.67    39,233.33    0.71178    27,925.51 Total value of cash inflow at PV from year 1 to 3          88,190 Present value of cash inflows for 3 years         88,190 present value of salvage value at end of 3 years (60,000x 0.0.71178)         42707 present value of total cash inflow       130,897 less present value of cash outflow equipment                                                                                                        120500 working capital 5500 Total cash outflow 126000 Net NPV 4,897

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