Question

Castle View has just paid a consulting firm $10,000 to evaluate the potential benefits and costs if it

purchases a more advanced glass extrusion machine to replace the one currently being used (the old

one) in its project. The consulting firm has come up with the following estimates:

• The project will last for another four years.

• The old machine was purchased at $900,000 four years ago. The depreciation method the firm uses

was straight-line method over five years with a salvage value of 0. The old machine is projected to

serve for another four years. If held to the end of four years later, the old machine could be sold for

$30,000. If sold now, the old machine could be sold for $35,000.

• The new machine costs $1,600,000. Its final salvage value is 0 at the end of its life. It falls into the

three-year property category for MACRS depreciation (Year 1: 33.33%, Year 2: 44.45%, Year 3:

14.81%, Year 4: 7.41%). The consulting firm believe that after 4 years, the new machine can be sold

for $300,000.

• It will require an upfront increase (in year 0) in net working capital of $50,000. During the project

life, the required NWC stays constant. In year 4, the firm expects to recover the NWC.

• The new machine will not change the revenue of the firm.

• The new machine will reduce COGS by $240,000 annually.

• Income taxes are paid at a 30% tax rate.

(1) What are the incremental depreciation, incremental CAPEX, and adjustment for cash flows

related to the sale of the new and the old equipment (incl. the selling price and related tax) from

year 0 to year 4?

(2) Calculate the expected annual incremental cash flows for years zero through four. (5 pts)

(3) If you were the CEO of the firm, will you accept the project according to NPV rule? Assume a

required return of 10%.

Answer 1

Project will not be accepted according to NPV rule because NPV is negative.

NPV = present value of cash flows - initial investment

Tax on sale of old machine is calculated as ($180,000 - $35,000)*30%. $180,000 is the book value of old machine at the end of year 4. $900,000 - [($900,000/5)*4] = $900,000 - $720,000 = $180,000

Tax on sale of new machine is calculated as $300,000 sale value - $0 book value = $300,000*30% = $90,000

	Years	0	1	2	3	4	Total
	Initial investment	$1,600,000					$1,600,000
	Savings in COGS	$0	$240,000	$240,000	$240,000	$240,000	$960,000
Less:	New Depreciation	$0	$533,280	$711,200	$236,960	$118,560	$1,600,000
Plus:	Old Depreciation	$0	$180,000	$0	$0	$0	$180,000
Less:	Taxes @30%	$0	-$33,984	-$141,360	$912	$36,432	-$138,000
Add back:	New Depreciation	$0	$533,280	$711,200	$236,960	$118,560	$1,600,000
Less:	Old Depreciation	$0	$180,000	$0	$0	$0	$180,000
Plus:	Sale of machines	$35,000	$0	$0	$0	$300,000	$335,000
Less:	Tax on Sale of machines	$43,500	$0	$0	$0	$90,000	$133,500
Less:	NWC	$50,000	$0	$0	$0	$0	$50,000
Plus:	Recovery of NWC	$0	$0	$0	$0	$50,000	$50,000
	Total cash flows	-$1,658,500	$273,984	$381,360	$239,088	$463,568	-$300,500
	NPV	-$597,997

Calculations