Question

Synlex Inc. is considering the purchase of a new machine for $600,000. It would cost $4,000 to install the machine. It would necessitate an increase of net working capital 120,000 at the initial time. It will result in an increase of sales revenue by $210,000 and an increase of maintenance cost by $40,000 per year. The machine has an expected life of 10 years, after which it will have salvage value of $50,000. Assume straight-line depreciation and the machine is being depreciated down to zero. The marginal tax rate is 40% and the required rate of return is 10%.

Required：

a. Calculate the machine’s initial investment.

b. Calculate the operating cash flows over the machine’s life.

c. Is it favorable for Synlex Inc. to purchase the machine?                   

(PVIFA 10%, 10 =6.1446; PVIFA 10%, 9=5.7590; PVIF 10%, 10 = 0.3855)

d. What other elements should Synlex consider in deciding whether to make this investment?

Answer 1

a)

The machine's initial investment = Cost of the machine + cost of installation + increase of net working capital

Initial investment = $ 600000 + $ 4000 + $ 120000 = $ 724000

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b)

Depreciation expense per year = $ 55000

Operating cash flow = ( Revenue - expenses - depreciation expense ) ( 1 - tax rate ) + depreciation

Operating cash flow = ( $ 210000 - $ 40,000 - $ 55000 ) ( 1 - 0.40) + $ 55000

Operating cash flow from year 1 to 10 = $ 124000

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c)

Terminal cash flow of the asset = After tax salvage value + Recovery of working capital

Terminal cash flow of the asset = $ 50000 ( 1 - 0.40) + $ 120000 = $ 150000

To decide if the purchase of the machine is favorable, we have to calculate the net present value of purchasing the machine.

Net present value = - $ 724000 + $ 124000 PVIFA ( 10%, 10 years) + $ 150000 PVIF ( 10%, 10 years)

Net present value = - $ 724000 + $ 124000 6.1446 + $ 150000 0.3855

Net present value = $ 95755.4 $ 95755

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d)

In deciding whether to make this investment, the firm should consider periodic maintenance costs required apart from the annual maintenance costs. The firm should also consider if the machine can be leased instead of making an outright purchase and whether lease option can help the firm to save costs.