Question

The Madison Prefabricated Buildings Co. is considering adding a new line to its product mix. Marcy Mulholland is to conduct a capital budgeting analysis on the project. The production line would be set up in unused space in Madison's main plant. The space could be leased out at $25,000 per year. The machinery's invoice price is approximately $200,000; $10,000 in shipping charges would be required; and it would cost $30,000 to install the machinery. The firm's inventories would have to be increased by $25,000 to handle the new line, but its accounts payable would rise by $5,000. The machinery has an economic life of 4 years, and qualifies as a MACRS 3-year asset. The machinery is expected to have a salvage value of $25,000 after 4 years. The new line would generate $125,000 in additional revenues in each of the next 4 years. The firm's marginal tax rate is 40% and its required return is 10 percent.

a. Construct the cash flows for each year by modifying an income statement. Be able to describe why you treated each cash flow as you did.

b. If the new product line decreases sales of the firm's other lines by $50,000 per year, should this information be included in the analysis? If so, how would Ms. Mulholland do it?

c. Determine whether the machine should be purchased. Explain your decision.

d. How much taxes did you save by having depreciation expense?

Answer 1

a		Calculation of cash flows:
		Year0	Year1	Year2	Year3	Year4	Comments
	Opportunity cost of leased space	0	0	0	0	0	It will be not be included in cash flows as it is just an opportunity cost. It will be considered while capital budgeting analysis
	Machine cost	-240000					Cost incurred on purchase of machinery,shipping cost and installation cost will be considered as cash flows
	Increase in inventory	-25000					Increase in inventory will be treated as increase in working capital outflow as cash will be blocked there
	Increase in accounts payable	55000					Increase in accounts payable will delay the cash outflow hence decreasing the working capital outflow.
	Tax savings on depreciation (Refer WN -1)		28380	25929	4754	1886	Tax savings on depreciation will increase the cash flow due to reduction in tax
	Salvage cost net of tax(25000*0.60)					15000	Salvage value is a cash inflow for year 4.
	Additional revenue net of tax(125000*0.60)		75000	75000	75000	75000	Additional revenues generated as a result of new project will be taken as cash inflow
	Total Cash flows after tax for each year	-210000	103380	100929	79754	91886
b.	Decrease in sales of other lines by 50000 will be deducted from cash flows of year that too net of taxes(50000*0.60)		-30000	-30000	-30000	-30000
	As a result of part B, cash flows for each year	-210000	73380	70929	49754	61886
c.	Whether machine should be purchased or not, it will include the opportunity cost of space that could be given on lease25000*0.60		15000	15000	15000	15000
	Total outflows/inflows	-210000	88380	85929	64754	76886
	Required rate of return @10% PVF	1	0.909	0.826	0.751	0.683
	Present value	-210000	80337.42	70977.35	48630.25	52513.1
	Net Present value	42458.17
	As we can see net inflows are positive, which means machine should be purchased as it will be generating inflows, thereby increasing the profits and covering up the initial cost machinery
d	Year	Opening Balance	Rates for MACRS 3 years	Depreciation	Closing balance	Tax savings on depreciation@40%
	Year1	215000	0.33	70950	144050	28380
	Year2	144050	0.45	64822.5	79227.5	25929
	Year3	79227.5	0.15	11884.13	67343.38	4753.65
	Year4	67343.38	0.07	4714.036	62629.34	1885.61
	Total tax savings due to depreciation expense				60948.3
	Tax provided on salvage value 25000*0.40					10000

	The rates for MACRS are the standard rates. This fixed rates will be used whenever MACRS 3 years is given in question. You may refer MACRS rate table.
WN-1	Cost of asset= 200000+10000+30000=	240000
	Less : salvage value	-25000	215000
	Year	Opening Balance	Rates for MACRS 3 years	Depreciation	Closing balance	Tax savings on depreciation@40%
	Year1	215000	33%	70950	144050	28380
	Year2	144050	45%	64823	79228	25929
	Year3	79228	15%	11884	67343	4754
	Year4	67343	7%	4714	62629	1886