Rooney, Inc. is considering the purchase of a new machine costing $600,000. The
ID: 434885 • Letter: R
Question
Rooney, Inc. is considering the purchase of a new machine costing $600,000. The machine's useful life is expected to be 7 years with no salvage value. The straight-line depreciation method will be used. The net increase in annual after tax cash flow is expected to be $152,000. Rooney estimates its cost of capital to be 15%. (The present value of a $1 annuity for 7 years at 15% is 4.160, and the present value of $1 to be received in 7 years is 0.376.)
The net present value of the investment in the machine under consideration is:
Upper level managers at Rooney, Inc. are concerned that employee estimates of future cash flows from the new machine may be overly optimistic. To what dollar amount can the annual after tax cash flow fall before the investment in the new machine should be rejected?
Explanation / Answer
Answer: - Given data
New machine cost = $600,000
Net increase in annual after tax cash flow expected= $152,000
Capital cost (15%) = $4.160
Net present value of investment in machine = Expected cash flow * Cost of capital - Machine cost
= $152,000 * $4.160 - $600,000
= $632320 - $600,000 = $32320
Net present value of investment in machine = $32320
To what dollar amount can the annual after tax cash flow fall before the investment in the new machine should be rejected is calculated by using the formula
= Machine cost / Capital cost
= $600,000 / $4.160 = $144231
So, $144231 amount can the annual after tax cash flow fall before the investment in the new machine should be rejected.
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