(New project analysis) Raymobile Motors is considering the purchase of a new pro

Question

(New project analysis) Raymobile Motors is considering the purchase of a new production machine for $600,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $150,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $35,000 after taxes. It would cost $7,000 to install the machine properly. Also, because the machine is extremely efficient, its purchase would necessitate an increase in inventory of $40,000. This machine has an expected life of 10 years, after which it will have no salvage value. Assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 31 percent marginal tax rate, and a required rate of return of 17 percent. a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with the termination of the project)? d. Should the machine be purchased?

Explanation / Answer

This problem has two alternatives

I) Taking inventory as initial outlay

a) Initial outlay = 600000 + 35000 + 7000 + 40000 = 682000

b) EBIT is after charging depreciation of 68200 i.e. 682000/10

EBIT = 150000 => Earnings after tax = 150000 - (150000*31%) = 103500

Annual cashflows = Earnings after tax + non cash expenses = 103500 + 68200 = 171700

c) Terminal Cash flow =Operating cash flows + salvage value = 171700+0 = 171700

d) Annuity factor for 10years @ 17% = 4.6586

Therefore, discounted cash flows = 171700*4.6586 = 799881.6

As, discounted cash flows > Initial outlay, machine can be purchased.

II) Inventory increase is accounted every year and increased EBIT is before considering the same

Initial outlay = 600000+35000+7000 = 642000

Depreciation = 642000/10 = 64200

EBIT = 150000-40000 = 110000

Earnings after tax = 110000 - (110000*31%) = 75900

Cash flows after tax = 75900 + 64200 = 140100

Discounted cash flows = 140100*4.6586 = 652670

In this case also, Dicounted cash flows > Initial outlay and the machine can be purchased.

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