Question

Warmack Machine Shop is considering a four-year project to introduce a new product. The project requires a new machinery. Buying the new machinery for $350,000 with $30,000 in shipping and $30,000 to intall, is estimated to result in incremental annual revenue of $200,000. The incremental variable cost is likely to be $25,000 and the incremental fixed cost is estimated to be $50,000. The inflation rate of 2.5% is estimated to affect Revenue, variable cost and the fixed cost going forward. The project falls in the MACRS five-year class, and it will have a salvage value at the end of the project of $55,000. As a part of the NWC requirment, an initial investment in inventory of $20,000 along with an additional $3,100 in inventory has to be made for each succeeding year of the project. If the shop's tax rate is 35 percent and its discount rate is 9 percent, should the company implement the project?

Answer 1

Calculation of cash outflow:

Cost of new machinery = 350000

Shipping costs = 30000

Installatioin costs = 30000

Initial working capital = 20000

Annual working capital= 3100 (3.8896) = 12057.76

(where 3.8896 is combined present value of yeat 1 to year 5 for additioanl working capital requirements.)

Total CASH OUTFLOW = 442057.76

Calculation of cash inflow:

Annual incremental revenue = 200000

less additional variable cost= 25000

less additional fixed cost= 50000

less depreciation= 82000 (410000/5)

________________

Income = 43000

less taxes = 15050 (35% tax )

net revenue/income = 27950

Add depreciation = 82000

cash flow after tax before depreciation =107950

compounding rate of inflation (deflation factor) = 107950* (1/1.025) =105317

+ 107959 * (1 / 1.025²) = 102809

+ 107950 * (1/1.025³) = 100232

+ 107950 * (1/1.025⁴​​) = 97780

   + 107950 * (1/1.025⁵) = 95395

_______________

Total inflation adjusted revenue = 501533

present palue of these cash flows = 391652

Add present value ofworking capital released at end (20000+ 15500) = 35500 * .650 = 23075 (pv value @ 9% end of

fifth year)

  

Add present value of salvage = 55000 * .650 = 35750

_________________________

Total revenue from project = 450477

PROFIT TO THE COMPANY (NPV) = TOTAL REVENUE - CASH OUTFLOW

= 450477 - 442057.76 = $ 8420

As project is generating postive NPV So, project can be accepted   

CALCULATION OF PRESENT VALUE OF CASH INFLOWS

YEAR	PV FACTOR @ 9%	PRESENT VALUE
1	105317	96575.69
2	102809	86462.36
3	100232	77379.10
4	97780	69228.24
5	95395	62006.75
	TOTAL	391652.14