Question

The Auto Express Diagnostics company is considering expanding their operations by purchasing a new hydraulic jack (to lift vehicles) with electronic diagnostics. It will require an immediate investment of $375,000 to get the compressor up and running. The air compressor has an expected life of 7 years and will be depreciated using a MACRS 10-year class schedule. The expected salvage value is $140,000. In addition to the cost of the equipment, this expansion will require an investment of $130,000 in net working capital at the outset. Based on exploratory conversations with other auto repair companies, the company projects the following incremental sales:

                        Year    Vehicle Diagnostics

3,500

4,000

4,500

5,000

5,100

5,500

5,500

Each diagnostic will be sold at $120 per diagnostic.

Labor costs associated with this project are expected to be $24,000 in year 1. These costs are expected to increase by 4% to 8% each year, with the most likely increase being 6%. Due to regional power issues, electricity prices can display wide swings. Thus, the company expects electricity costs to be $25,000 in year 1, with annual increases of 7% to 9%. No single value in that range is more likely to occur than any other. Fixed costs are expected to remain unchanged at $74,000 each year.

The weighted average cost of capital used to evaluate a project of this risk is 10 percent (with a standard deviation of 1.5 percent). The relevant tax rate is 40 percent. Based on this information, assist the Auto Express Diagnostics Company in making the right decision as to whether or not purchase the hydraulic diagnostic jack

Answer 1

Net present value for the net cash flow generated from the expansion plan is positive i.e. $ 660069 and IRR is higher than weightage cost of capital. Therfore Auto Express Company should go ahead with purchasing the diagnostic jack as it is an attaractive invetsment.

Depreciation is not considered as it is non cash item. It may have impact on tax payment (redcution in tax) but that will only increase the net cash flow, that inturn will increase IRR and NPV.

answered by: anonymous