Question

A company is evaluating the purchase of a machine to improve product quality and output levels. The new machine would cost $1.6 million and would be depreciated for tax purposes using the straight-line method over an estimated six-year life to its expected salvage value of $100,000. The new machine would require an addition of $70,000 to working capital at the beginning of the project, which will of course be returned to the firm at the end of the project. In each year of the machine's life, the machine would increase the company's pre-tax cash receipts by $400,000 from their current level. During each of the six years, cash operating costs would increase by $15,000 from their current level. In addition, at the end of the 4th year, a major repair of the machine costing $40,000 (pre-tax) would be required. The company has a 8% overall cost of capital and is in the 35% marginal tax bracket.

Part 1: Prepare a Cash Flow Spreadsheet that identifies the incremental cash flows for each year of the machine's life.

Part 2: Calculate the investment's net present value (NPV).

Answer 1

Calculation of Depreciation = 1,600,000 - 100,000 / 6 = 250,000 per year

Initial outflow in year 0
Base price + modification	1,600,000
Increase in working capital	70,000
Total	1,670,000

Calculation of Annual Cash flow after tax

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Increse in pre tax reciepts	400,000	400,000	400,000	400,000	400,000	400,000
Less : Increse in operating cost	15,000	15,000	15,000	15,000	15,000	15,000
Less : Repair				40,000
Less : Depreciation	250,000	250,000	250,000	250,000	250,000	250,000
Earning Before Tax	135,000	135,000	135,000	95,000	135,000	135,000
Tax @ 35%	47,250	47,250	47,250	33,250	47,250	47,250
Earning after tax	87,750	87,750	87,750	61,750	87,750	87,750
Add : Tax benefit on depreciation	87,500	87,500	87,500	87,500	87,500	87,500
Cash flow after tax	175,250	175,250	175,250	149,250	175,250	175,250
PV @ 8%	162,269	150,249	139,119	109,703	119,272	110,437

Total of PV of Cash flow after tax = 7,91,049

Calculation of PV of terminal Value at the end of Year 6

Sale Value of Fixed Assets	100,000
Recovery of working capital	70,000
Total	170,000
PV @ 8%	107,129

NPV = PV of Annual Benefit + PV of terminal Value - Inital Investment

NPV = 7,91,049 + 107,129 - 1,670,000 = -771,822