Question

The Lagos Leather Corporation is considering replacing the drill press that it currently uses to manufacture handbags. The drill press, purchased just 2 years ago, is being depreciated on a straight-line basis and has 6 years of remaining life. Its current book value is $1,800, and it could be sold on an Internet auction site for $4,500 at this time. The annual depreciation expense on the press will be $300 per year for the remaining 6 years of its life. If the old press is not replaced, it will have a salvage value of $800 at the end of its useful life.

Lagos is considering purchasing a new higher-end drill press, which costs $7,900, and has an estimated useful life of 6 years with an estimated salvage value of $800. This drill press falls into the MACRS 5-years class, so the applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. The new drill press is faster and would allow for an output expansion, so sales would rise by $2,000 per year; even so, the new machine's much greater efficiency would reduce operating expenses by $1,400 per year. To support the greater sales, the new drill press would require that inventories increase by $2,900, but accounts payable would simultaneously increase by $700. Lagos’s marginal federal-plus-statetax rate is 40%, and its WACC is 13%.

What is the initial investment outlay?

	$5,480
	$6,880

	$8,880
	$10,280

Answer 1

Initial investment is the amount required to start a business or a project. It is also called initial investment outlay or simply initial outlay. It equals capital expenditures plus working capital requirement plus after-tax proceeds from assets disposed off or available for use elsewhere.

The calculation will be : Initial Investment = Capital Expenditures + Increase in Working Capital ? Disposal Inflows

7900 + 40% tax - reduction on operating expenses - disposal inflows .

= 7900+3140-1400-800 = 8860 . ( Nearest value)

Option 3 is correct answer.