Question

HT Tool Co is considering the purchase of a new CNC milling machine to enhance the quality of its custom fabrication services. This project is not expected to change sales, but should save the firm in labor costs. The annual labor savings is expected to be $74,350 (before tax) but the machine will use more electrical power, which is expect to cost $2,400 each year. The machine costs $145,000. It will require $21,000 in modifications to support the needs of HT Tool. An increase in inventory (net working capital) of $5,150 will be necessary.  The machine will be depreciated using MACRS with a 3-year class life (half-year convention).  The firm’s tax rate is 35%.  The plan is to sell the machine after 3 years and the expected selling price then is estimated at $65,000.  The hurdle rate for this project is 10.5% Begin with a blank unused worksheet and show your setup: a. What is the initial investment of this project? (Year 0 net cash flow). b. What are the net operating cash flows for years 1, 2, and 3? c. What is the terminal (NOT operating) cash flow in year 3? d. What are the NPV and IRR for this project? e. Should be accepted?

Answer 1

Solution A

Calculation of initial investment
Cost of machine	$        145,000
Modification cost	$          21,000
Cost of machine installed	$        166,000
Working capital	$            5,150
Initial investment	$       171,150

Solution B: Calculation of operating cash flow
Tax rate		35%
	Year-0	Year-1	Year-2	Year-3
Saving in labor cost		$            74,350	$            74,350	$             74,350
Additional electricity cost		$              2,400	$               2,400	$               2,400
Contribution		$           71,950	$            71,950	$             71,950
Less: Depreciation as per table given below		$            55,328	$            73,787	$             24,585
Profit before tax		$           16,622	$            (1,837)	$             47,365
Tax		$              5,818	$                (643)	$             16,578
Profit After Tax		$           10,804	$            (1,194)	$             30,788
Add Depreciation		$            55,328	$            73,787	$             24,585
Cash Profit After tax		$           66,132	$            72,593	$             55,372

Solution C: Calculation of terminal cash flow in year 3
Cost of machine	$       145,000
Modification cost	$          21,000
Depreciable cost	$        166,000
Depreciation	$        153,699
WDV	$          12,301
Sale price	$          65,000
Profit/(Loss)	$          52,699
Tax	$          18,445
Sale price after tax	$          46,555
recovery of working capital	$            5,150
Terminal cash flow	$          51,705

Solution D
Calculation of NPV
						10.50%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor	Present values
0		$        (166,000)	$             (5,150)		$    (171,150)	1.0000	$    (171,150)
1			$                     -	$             66,132	$       66,132	0.9050	$       59,848
2			$                     -	$             72,593	$       72,593	0.8190	$       59,452
3		$            46,555	$               5,150	$             55,372	$     107,077	0.7412	$       79,362
					Net Present Value		$       27,512

Calculation of IRR
			18.00%		19.00%
Year		Total cash flow	PV factor @ 18%	Present values	PV factor @ 19%	Present values
0		$        (171,150)	1.000	$         (171,150)	1.000	$         (171,150)
1		$            66,132	0.847	$             56,044	0.840	$             55,573
2		$            72,593	0.718	$             52,135	0.706	$             51,263
3		$         107,077	0.609	$             65,171	0.593	$             63,541
				$               2,200		$                (773)
		IRR	=Lower rate + Difference in rates*(NPV at lower rate)/(Lower rate NPV-Higher rate NPV)
		IRR	'=18%+ (19%-18%)*(2199.95/(2199.95-(-772.73)
			18.740%

Solution E: Decision

Since Project is having positive NPV and IRR more than hurdle rate, hence the project should be selected