Question

​(Calculating project cash flows and​ NPV)  The Guo Chemical Corporation is considering the purchase of a chemical analysis machine. The purchase of this machine will result in an increase in earnings before interest and taxes of ​$90,000 per year. The machine has a purchase price of $400,000​,and it would cost an additional $7,000 after tax to install this machine correctly. In​ addition, to operate this machine​ properly, inventory must be increased by $12,000.This machine has an expected life of 10 ​years, after which time it will have no salvage value. ​ Also, 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 of 7 percent.

a.  What is the initial outlay associated with this​ project?

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 flow associated with termination of the​ project)?

d.  Should this machine be​ purchased?

Answer 1

a. The initial outlay associated with the project is : cost of machine + installation charges + working capital investment.

= $400,000​ + $7,000 + $12,000

= $4,19,000

b. The depreciation charged as per the straight line method is :

$4,07,000/10 = $40,700

b. So, the annual cash flow associated with the project is :

EBIT( 1 - TAX RATE ) + DEPRECIATION

= $90,000( 1 - 0.36) + $40,700

= $98,300

This will continue for year 1 to 9.

c. The terminal cash flow is = $98,300 + $12,000 (the investment of working capital will be recovered back)

=$110,300

d. Now computing the NPV of the project we get,

CF0 = ($419,000)

CF1 = $98300

CF1- CF9 = $98,300

CF10 = $110300

Discount rate = 7%

NPV = $2,77,518.257

YES, as we are getting a positive NPV, the project should be purchased.