Question

ROST Corporation is a manufacturer of a variety of kitchen utensils. In order to improve the
quality of existing products, the production manager of the company proposes to replace a
machine used in the molding process. As a financial manager of the company, you are
responsible for assessing the feasibility of this project. After a preliminary study, it is
estimated that the new project will generate additional sales revenue of $310,200 in each of
the next four years. It is known that the company faces a marginal tax of 26% and wants a
17% required rate of return. In addition, the company employs the straight-line method to
compute its depreciation. To finance the project, the company would have to borrow
$1,200,000 at 10% interest from its bank. Other findings of the study are presented as
follows:
Old Machine New Machine
Initial purchase price $1,120,000 $960,000
Tax life 20 years 4 years
Age 16 years 0 years
Expected salvage value $0 $0
Current market value $224,000 N.A.
Annual cash expense $360,000 $380,000
(a)
(b)
(c)
Determine the annual after-tax cash flows associated with this project.
Determine whether you would accept or reject the project if the net present
value rule is used.
Without doing any calculation, how would you reply to your boss if he told you
to evaluate this project by the internal rate of return rule rather than the net
present value rule? (word limit: 150 words)

Answer 1

This problem will be solved with incremental method .

Particulars	Amount
Additional Sales Revenue	3,10,200
Less:
Incremental Cash Expenses ($3,80,000 -$ 3,60,000)	20,000
Incremental Depreciation [ ( 9,60,000/4)-(11,20,000/20) = 1,84,000]	1,84,000
Interest Payable (10/100 *12,00,000)	1,20,000
Profit Before Tax	( 13,800)
+ Tax ( Since it is a loss company gets benefit @ 26%)	3,588
Profit after Tax	(10,212)
+ Depreciation (Non - Cash Expense)	1,84,000
a) After - Tax Cash flows each year	1,73,788
b)Present value of Cash flows @ 17% for 4 years ( 1,73,788 * 2.7432)	4,76,735
Initial Outlay :-
Purchase Price of New Machine	9,60,000
Less: Current Market Value of Old Machine	2,40,000
Initial Outlay	7,36,000
Net Present Value of the Project :-
Net Presnt Value of Cash flows	4,76,735
Less: Initial Outlay	7,36,000
Net Present value of the project	( 2,59,265)

Since Net Present Value of the project is negative ,that is ,loss , so the company should reject the project.