Question

1. Elga Co. is considering the purchase of a new production machine for $750,000 and the installation cost would be $50,000. Sales will be $480,000 per year and annual operating costs (exclusive of depreciation) will be $200,000. The purchase of this machine would necessitate an increase in inventory of $100,000. This machine has an expected life of five years and the salvage value is $50,000. Assume that straight-line depreciation is used.

The firm’s cost of capital is 14%, and the firm’s tax rate is 30%.

1. What is the initial outlay associated with this project?
2. What are the annual after-tax cash flows associated with this project, for years 1 to 5?
3. Should this machine be purchased?

Answer 1

a. The initial cash outlay is :

Investment in machinery + installation costs + working capital investment

= $750,000 + $50,000 + $1,00,000

= $9,00,000

b. The depreciation charges will be :

= (Value of equipment + installation charges - salvage value) / 5

= $750,000 + $50,000 - $50,000/ 5

= $150,000

So, the operating cash flows is for year 1 to 5 is :

= ( Sales - costs) * (1 - tax rate ) + depreciation tax shield

= ($480,000 - $2,00,000) * (0.7 ) + $150,000* 0.3

= $196,000 + $45,000

= $241,000

c. So, the NPV of the machine is :($72,627.4865) . As the NPV of the machine is negative, the machine should not be purchased.