Question

(Calculating project cash flows and NPV) Raymobile Motors is considering the purchase of a new production machine for $550,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $180,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $23,000 after tax. In addition, it would cost $6,000 after tax to install this machine correctly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $24,000. This machine has an expected life of 10 years, after which it will have no salvage value. Assume simplified straight-line depreciation, that this machine is being depreciated down to zero, a 36 percent marginal tax rate, and a required rate of return of12percent.

a. What is the initial outlay associated with this project? (Round to nearest dollar)

b. What are the annual after-tax cash flows associated with this project for years 1 through 9?

c. What is the terminal cash flow in year 10 (that is, the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project)?

d. Should this machine be purchased?

Answer #1

a.Initial Outlay is calculated as follows:

Purchase cost = $550,000

Training cost = $23,000

Installation cost = $6,000

Increase in Inventory = $24,000

Initial Outlay = $603,000

b.Calculation of annual after tax cash flows:

Annual EBIT = $180,000

less: tax @36% = $64,800

Earnings after tax = $115,200

Add: Depreciation (non-cash) = (550,000+6,000)/10 = $55,600

Annual cash flow = $170,800

c.Terminal cash flow:

Annual cash flow = $170,800

Add: Release if inventory = $24,000

Terminal Cash flow in Year 10 = $194,800

d.NPV = Present Value of cash inflows - present value of cash outflows

= 170,800*PVAF(12%, 10 years) + 24,000*PVF(12%, 10 years) - 603,000

= 170,800*5.65022 + 24,000*0.32197-603,000

= $369,785.37

Hence, the machine should be purchased since positive NPV

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