Question

CMS Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $545,000 is estimated to result in $97,000 in annual pretax cost savings. The press falls in the MACRS five-year class, and it will have a salvage value of $70,000. The press also requires an initial working capital of $21,000, along with an additional $3,000 in working capital for each succeeding years of project. The tax rate is 34%, and the company's required rate of return is 11%. Should the company buy the machine?

Answer 1

Initial Investment = $545,000
Useful Life = 4 years

Depreciation Year 1 = 20.00% * $545,000
Depreciation Year 1 = $109,000

Depreciation Year 2 = 32.00% * $545,000
Depreciation Year 2 = $174,400

Depreciation Year 3 = 19.20% * $545,000
Depreciation Year 3 = $104,640

Depreciation Year 4 = 11.52% * $545,000
Depreciation Year 4 = $62,784

Book Value at the end of Year 4 = $545,000 - $109,000 - $174,400 - $104,640 - $62,784
Book Value at the end of Year 4 = $94,176

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $70,000 - ($70,000 - $94,176) * 0.34
After-tax Salvage Value = $78,219.84

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$545,000 - $21,000
Net Cash Flows = -$566,000

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $97,000 * (1 - 0.34) + 0.34 * $109,000
Operating Cash Flow = $101,080

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $101,080 - $3,000
Net Cash Flows = $98,080

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $97,000 * (1 - 0.34) + 0.34 * $174,400
Operating Cash Flow = $123,316

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $123,316 - $3,000
Net Cash Flows = $120,316

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $97,000 * (1 - 0.34) + 0.34 * $104,640
Operating Cash Flow = $99,597.60

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $99,597.60 - $3,000
Net Cash Flows = $96,597.60

Year 4:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $97,000 * (1 - 0.34) + 0.34 * $62,784
Operating Cash Flow = $85,366.56

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $85,366.56 + $30,000 + $78,219.84
Net Cash Flows = $193,586.40

Required Return = 11%

NPV = -$566,000 + $98,080/1.11 + $120,316/1.11^2 + $96,597.60/1.11^3 + $193,586.40/1.11^4
NPV = -$181,835.78

No, the machine should not be purchased since NPV is positive.