Company X\'s management is evaluating a piece of machinery that costs $2 million
ID: 2728338 • Letter: C
Question
Company X's management is evaluating a piece of machinery that costs $2 million. This machine will provide revenues of $500,000 each year and operating coats will be $130,000 each yew. it is to be depreciated to a zero book value over ten sears using the straight-line method. The company will use the machine for only eight yearn. At (he end of eight years it is expected to have no salvage value. The now machine will require additional working capital of $200.000 Company X is profitable and experts to continue paying taxes at 35%. Given the risk involved in this project, investors require a return of 12%. Answer the following questions What is the time-zero cash flow of buying the machine? What is the recurring annual cash flow, for years I through 8, of buying the machine? What is the end-period (year 8) cash flow effect of buying the machine? This is in addition to the year 10 cash flow in part (b). Should the company buy the machine?Explanation / Answer
Part A
Time zero cash flow would be the amount of initial investment.
Year 0 cash outflow = investment in asset + working capital requirement
= 2,000,000 +200,000
= 2,200,000
Part B
Annual depreciation = (Cost of asset – salvage value)/ useful life
= (2,000,000 -0)/ 10
= 200,000
Depreciation tax shield = 200,000 x 35%
= 70,000
Annual cash flow = (Revenue – costs) x (1- tax rate) + Depreciation tax shield
= (500,000 – 130,000) x (1-0.35) + 70,000
= 310,500
Part C
Book value of machinery at the end of year 8 = 2,000,000 – 200,000 x 8
= 400,000
Tax benefit on capital loss = (400,000 -0) x 35%
= 140,000
Terminal cash flow = tax benefit on capital loss + working capital recovered
= 140,000 + 200,000
= 340,000
Part D
We can calculate Net Present Value of the project to determine whether the project should be accepted or not.
Net present value is the sum of present values of the cash flows.
Year
Cash flow
PV factor 12%
PV
0
-2200000
1
-2200000
1
310500
0.892857143
277232.1
2
310500
0.797193878
247528.7
3
310500
0.711780248
221007.8
4
310500
0.635518078
197328.4
5
310500
0.567426856
176186
6
310500
0.506631121
157309
7
310500
0.452349215
140454.4
8
310500
0.403883228
125405.7
8
340000
0.403883228
137320.3
-520228
Since the NPV of the project is less than zero, this project should not be accepted.
Year
Cash flow
PV factor 12%
PV
0
-2200000
1
-2200000
1
310500
0.892857143
277232.1
2
310500
0.797193878
247528.7
3
310500
0.711780248
221007.8
4
310500
0.635518078
197328.4
5
310500
0.567426856
176186
6
310500
0.506631121
157309
7
310500
0.452349215
140454.4
8
310500
0.403883228
125405.7
8
340000
0.403883228
137320.3
-520228
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