You have been asked by the president of your company to evaluate the proposed ac
ID: 2756754 • Letter: Y
Question
You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose machine. The machine's basic price is $1,000,000 and our accountant requires that it be written off over its 5 year class using straight line depreciation to a book value of $0. Purchase of the machine would require an increase in net working capital of $20,000 at t=0 only. The machine would increase the firm's before tax revenues by $960,000 per year but would also increase operating costs by $100,000 per year. It is expected to be used for 3 years and then be sold for $800,000. The firm's marginal tax rate is 40 percent, and the project's cost of capital is 18 percent. (Please show your work)
a) What is the net investment required at t=0?
b) What are the operating cash flows each year?
c) What is the total value of ending (non operating) cash flow in year 3?
d) What is the project's NPV?
Explanation / Answer
a)
Net investment at time 0 = Basic price of machine + Net working capital = $1,000,000 + $20,000 = $1,020,000
b)
Annual depreciation on machine = $1,000,000 / 5 = $200,000
Before tax revenue = $960,000
Operating costs = $100,000
Net profit before tax = $960,000 - $100,000 - $200,000 = $660,000
Post tax operating income = $660,000 * (1 – 0.40) = $396,000
Operating cash flows per annum = Operating income after tax + Depreciation = $396,000 + $200,000 = $596,000
c)
Non operating cash flow in year 3 = Receipt on sale of machine + Recapturing of net working capital
Book value of machine at the end of year 3 = $1,000,000 – ($200,000*3) = $400,000
Capital gain on sale of machine = $800,000 - $400,000 = $400,000
Tax on sale of machine = $400,000 * 0.40 = $160,000
Net receipt of sale of machine = $800,000 - $160,000 = $640,000
Non operating cash flow in year 3 = $640,000 + $20,000 = $660,000
d)
Net present value = -$1,020,000 + $596,000/1.18 + $596,000/1.182 + $596,000/1.183 + $660,000/1.183 = $677,563
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