You have been asked by the president of your company to evaluate the proposed ac

Question

You have been asked by the president of your company to evaluate the proposed acquisition of a new machine. The company spent $10,000 to survey the market whether the new machine would be effective in production. The machine’s basic price is $50,000, and it will cost another $10,000 to install. The employees are supposed to obtain a training session before operating the machine, costing $4,000. The machine can be sold after four years for $8,000. Use of the machine will require an increase in account receivables by $5,000, a decrease in inventory by $4,000, and an increase in account payables by $12,000. The machine is expected to increase the sales revenue by $5,000, but it is expected to save the firm $10,000 per year in operating costs, mainly labor. To acquire this new machine, the firm would have to borrow $20,000 at 10% interest from its local bank, resulting in interest payments of $2,000 per year. The machine falls into the 4-year straight-line method for depreciation. The firm’s marginal tax rate is 34%. Assume the required rate of return is 10%.

(a)     (5 points) What is the initial outlay associated with this project?

(b)     (4 points) What is the operating cash flow per year?

(c)     (4 points) What is the terminal cash flow?

(d)     (2 points) Find the NPV. Should the machine be purchased? Explain.

Explanation / Answer

1. $10,000 used for survey is sunk cost, so we need to ignore it for capital budgeting.

2. Working Capital = Change in Current Assets - Change in Current Liabilities = (5000-4000) - 12000 = - 11,000

Working Capital is negative which implies that we can save 11,000 in cash flows from working capital. We also need to remember that we need to put the working capital back in the company when we sell the machine after four years.

3. Revenues and cost savings are 5000 and 10000 respectively. Depreciation is straight line = 50000/4 = 12,500. Interest expense is 2,000 and tax rate is 34%.

4. Operating Cash Flow = Net Profits + Depreciation = 330 + 12500 = 12830

5. Initial Outlay = -50,000 - 10,000 - 4,000 + 11,000 = -53,000

6. Terminal Cash Flow = -11,000 + 8,000 x (1 - 34%) = -5,720

7. NPV = NPV (10%, 12830...7110) - 53000 = -16,237, which is negative. A negative NPV indicates that we are not adding any value to the company by purchasing the machine. So, we should not be purchasing the machine.

Capital Investment -$50,000 Installation -$10,000 Training -$4,000 Working Capital $11,000 -$11,000 Salvage Value $8,000 Revenues $5,000 $5,000 $5,000 $5,000 Cost Savings $10,000 $10,000 $10,000 $10,000 Depreciation -$12,500 -$12,500 -$12,500 -$12,500 Interest Expense -$2,000 -$2,000 -$2,000 -$2,000 PBT $500 $500 $500 $500 Taxes (34%) -$170 -$170 -$170 -$170 Net Profits $330 $330 $330 $330 Free Cash Flows -$53,000 $12,830 $12,830 $12,830 $7,110 NPV -$16,237

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