Question

Cash flows estimation and capital budgeting:
You are the head of finance department in XYZ Company. You are considering adding a new machine to your production facility. The new machine’s base price is $10,000.00, and it would cost another $2,140.00 to install it. The machine falls into the MACRS 3-year class (the applicable MACRS depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%), and it would be sold after three years for $1,750.00. The machine would require an increase in net working capital (inventory) of $810.00. The new machine would not change revenues, but it is expected to save the firm $33,605.00 per year in before-tax operating costs, mainly labor. XYZ's marginal tax rate is 34.00%.

a. What is the initial cash outlay? (4 pts.)
b. What is the free cash flow for year 1? (4 pts)
c. What is the additional Year-3 cash flow (i.e, the after-tax salvage and the return of working capital – also called terminal value)? (4 pt)

Answer 1

a). Initial Cash Outlay = Machine's Base Price + Installation Cost + Increase in NWC

= $10,000 + $2,140 + $810 = $12,950

b). Cost of Machine = Machine's Base Price + Installation Cost

= $10,000 + $2,140 = $12,140

FCF(Year 1) = [Increase in Savings * (1 - t)] + [Depreciation * t]

= [$33,605 * (1 - 0.34)] + [$12,140 * 0.3333 * 0.34]

= $22,179.30 + $1,375.73 = $23,555.03

c). Book Value after 3 years = Cost of Machine * (1 - Accumulated Depreciation Rate)

= $12,140 * [1 - (0.3333 + 0.4445 + 0.1481)]

= $12,140 * [1 - 0.9259]

= $12,140 * 0.0741 = $899.57

After-tax Salvage Value = Salvage Value - [Tax Rate * (Salvage Value - Book Value after 3 years)]

= $1,750 - [0.34 * ($1,750 - $899.57)]

= $1,750 - [0.34 * $850.43]

= $1,750 - $289.14 = $1,460.86

Terminal Value = After-tax Salvage Value + Return of Working Capital

= $1,460.86 + $810 = $2,270.86