Question

Mega Machines is considering a 3-year project with an initial cost of $618,000. The project will not directly produce any sales but will reduce operating costs by $265,000 a year. The equipment is depreciated straight-line to a zero book value over the life of the project. At the end of the project the equipment will be sold for an estimated $60,000. The tax rate is 34%. The project will require $23,000 in extra inventory for spare parts and accessories. Should this project be implemented if Thornley's requires a 9% rate of return? Why or why not?

Please show all work

Answer 1

We will calculate NPV first

Annual operating cash flow = Cost savings - Depreciation -Tax + Depreciation

= 265000-[618000/3 ] - [ 265000-[618000/3]*34%] + -[618000/3 ] = 244,940

NPV = Present value of cash inflows - Initial cash outlay

= 244,940*PVIFA,9%,3 + 60,000(1-.34)*PVIF,9%,3 + 23,000*PVIF,9%,3 - [618000+23000]

=244940*2.531295 + 39,600*.772183 + 23,000*.772183 - [618000+23000]

=620,015.31+30,578.45+17,760.22 -  [618000+23000]

=27,354

Since the NPV is positive,project can be implemented.

NOTE

-The formula for calculating the Present Value Annuity Inflow Factor (PVIFA) is [{1 - (1 / (1 + r)n} / r], where “r” is Discount rate and “n” is the useful life of investment

-The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)n], where “r” is Discount rate and “n” is the useful life of investment