Explain question in full. Show all work. (15 points) Pierre Imports is evaluatin

Question

Explain question in full. Show all work. (15 points)

Pierre Imports is evaluating the proposed acquisition of new equipment at a cost of $90,000. In addition the equipment would require modifications at a cost of $10,000 plus shipping costs of $2,000. The equipment falls in the MACRS 3 year class and will be sold after 3 years for $35,000. The equipment would require increased inventory of $6,000. The equipment is expected to save the company $35,000 per year in before-tax operating costs. The company’s marginal tax rate is 30 percent and its cost of capital is 11%.

a. What is the cash outflow at Time 0?

b. What are the net operating cash flows in years 1, 2, and 3?

c. Calculate the non-operating terminal year cash flow.

d. Calculate net present value. Should the machine be purchased?

e. What is the Cost of capital?

Explanation / Answer

Part A)

The cash flow at Time 0 is calculated as follows:

Cash Flow at Time 0 = -90,000 (Cost of Equipment) - 10,000 (Modifications) - 2,000 (Shipping Costs) - 6,000 (Increase in Working Capital) = -$108,000

________

Part B)

The net operating cash flows are calculated with the use of following table:

Notes:

Depreciation is calculated on the total value of equipment which is $102,000.

________

Part C)

The non-operating terminal cash flow is calculated with the use of following table:

________

Part D)

NPV is the difference between the present value of cash inflows and cash outflows. The formula for calculating NPV is given below:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Cost of Capital)^1 + Cash Flow Year 2/(1+Cost of Capital)^2 + Cash Flow Year 3/(1+Cost of Capital)^3

________

Using the values calculated in Part 1, 2 and 3, we get,

NPV = -108,000 + 34,699/(1+11%)^1 + 38,102/(1+11%)^2 + (29,032 + 32,767)/(1+11%)^3 = -$628.31

The machine shouldn't be purchased as it results in a negative NPV of -$628.31.

________

Part E)

The cost of capital is 11% which is already provided in the question.

Year 1 2 3 Annual Savings 35,000 35,000 35,000 Less Depreciation 33,997 (102,000*33.33%) 45,339 (102,000*44.45%) 15,106 (102,000*14.81%) Savings after Depreciation 1,003 -10,339 19,894 Less Taxes (30%) 301 -3,102 5,968 Savings after Depreciation and Taxes 702 -7,237 13,926 Add Depreciation 33,997 45,339 15,106 Net Operating Cash Flow $34,699 $38,102 $29,032

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