You have a business making widgets. You are considering buying a new machine whi

Question

You have a business making widgets. You are considering buying a new machine which costs $750,000. You expect to be able to sell it for $120,000 at the end of its useful life in 7 years and will straight-line depreciate it. You are going to take a robot arm off an old machine to use to run the new one. The old machine could be sold for $30,000 today if you didn’t take parts off it, but is worthless without the robot arm. You also have some old material that you’re not using, which you had bought for $20,000 to make a prototype for some possible new products. You think you will be able to sell a new type of widget that you will make on this machine. You expect to sell 35,000 per year at $40 each. You expect $45,000 in fixed costs, and variable cost of 80% of sales on the new widgets. You also expect to need additional Net Working Capital to start the project of $25,000, which you will recover in Year 7. Your tax rate is 35% and your cost of capital is 10%.

a. Calculate the Initial Investment of the project, and the Terminal Cash Flow of the project.

b. Calculate the Operating Cash Flow (OCF) for EACH YEAR of the project. Remember to calculate the EBIT and show each item that goes into the OCF on its own row, and label each row you use.

c. Calculate the Total Cash Flow for EACH YEAR of the project.

d. Calculate the project’s NPV (NOTE: The Excel NPV function may not work the same way as your calculator’s NPV function. If you use it, make sure to use the NPV function correctly). i. State whether the firm should accept or reject the project based on NPV. ii. Explain why you accepted or rejected the project based on NPV. In other words, what does it mean for the NPV to be positive or negative (whichever you calculated)?

e. Calculate the project’s IRR (use the Excel IRR function). Based on IRR, should the firm accept the project? i. State whether the firm should accept or reject the project based on IRR. ii. Explain why you accepted or rejected the project based on IRR (i.e., what does IRR measure)?

f. Calculate the Payback Period in years (to 1 decimal place). i. The Comptroller has a 3-year minimum payback. State whether they would accept or reject the project? ii. Cite one reason why either NPV or IRR are better for evaluating projects than Payback Period.

Explanation / Answer

$20,000 is sunk cost and will not be used in capital budgeting.

Find the table as asked in part a through d

Total initial investment = $805000

Less: Depreciation

(750000/7)

NPV = 174071.95

Project will be accepted because NPV is positive.

IRR using excel function '=IRR(Terminal Cashflows)' = 15.99% = 16%

IRR is 16% and higher than required cost of capital of 10% . Hence project must be accepted based on IRR.

Payback period can be calculated by looking at terminal cashflows. How many years would it take to recoup initial investment of $805000 ?

Inthe first 4 years, we will have recouped 190250*4 = $761000

The remaining (805000-761000) $44000 will be recouped in a fraction of fifth year.

if it takes all of fifth year to recoup 190250 , then what fraction of year would be required to recoup 44,000

44,000/190250 (= 0.2313) of the fifth year will be enough to recoup remaining amount

So total payback period = 4 years + 0.2313 years = 4.2313 years

Year 0 1 2 3 4 5 6 7 Initial investment -750000 Opportunity loss from not selling -30000 Working capital -25000 Annual revenues (35000*$40) 1400000 1400000 1400000 1400000 1400000 1400000 1400000 Less: Fixed costs 45000 45000 45000 45000 45000 45000 45000 Less: Variable costs (80% of Revenues) 1120000 1120000 1120000 1120000 1120000 1120000 1120000

Less: Depreciation

(750000/7)

107142.86 107142.86 107142.86 107142.86 107142.86 107142.86 107142.86 EBIT = Revenues - fixed costs - variable costs- depreciation 127857.14 127857.14 127857.14 127857.14 127857.14 127857.14 127857.14 Net Income = EBIT(1- taxrate) 83107.14 83107.14 83107.14 83107.14 83107.14 83107.14 83107.14 Depreciation 107142.86 107142.86 107142.86 107142.86 107142.86 107142.86 107142.86 Working capital released 25000 Operating cashflow = Net Income + Depreciation+ WC changes 190250 190250 190250 190250 190250 190250 215250 After tax salvage value 78000 Terminal cashflow = OCF + Salvage value 190250 190250 190250 190250 190250 190250 293250 Present value of tax flows (discount by (1+10%)^t) -805000 172954.54 157231.40 142937.64 129943.31 118130.28 107391.16 150483.62

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