Question

Mid-Michigan Manufacturing Inc. (MMMI) wishes to determine whether it would be advisable to replace an existing production machine with a new one. The have hired your firm as a consultant to determine whether the new machine should be purchased. The data you will need is as follows:

   MMMI has decided to set a project timeline of 4 years.
   The new machine will cost $1,100,000. It will be depreciated (straight line) over a five-year period (its estimated useful life), assuming a salvage value of $100,000.

   The old machine, which has been fully depreciated, could be sold today for $253,165. The company has received a firm offer for the machine from Williamston Widgets, and will sell it only if they purchase the new machine.

   Additional Sales generated by the superior products made by the new machine would be $665,000 in Year 1. In Years 2 & 3 sales are projected to grow by 8.5% per year. However, in Year 4, sales are expected to decline by 5% as the market starts to become saturated.

   Total expenses have been estimated at 60.75% of Sales.

   The firm is in the 21% marginal tax bracket and requires a minimum return on the replacement decision of 9%.

   A representative from Stockbridge Sprockets has told MMMI that they will buy the machine from them at the end of the project (the end of Year 4) for $100,000. MMMI has decided to include this in the terminal value of the project.

   The project will require $100,000 in Net Working Capital, 54% of which will be recovered at the end of the project.

The calculations are done on excel.

1. What is the year 4 total cash flow?

2. What is the year 3 operating cash flow?

Answer 1

Part 1)

The value of year 4 total cash flow is determined as below:

Sales [665,000*(1+8.5%)^2*(1-5%)]	743,711.89
Less Expenses (743,711.89*60.75%)	451,804.98
Depreciation [(1,100,000-100,000)/5]	200,000.00
Earnings before Taxes	91,906.92
Less Taxes	19,300.45
Earnings after Taxes	72,606.47
Add Depreciation	200,000.00
Operating Cash Flow	272,606.47
Add After-Tax Salvage Value of Machine [100,000*(1-21%)]	79,000.00
Recovery of Working Capital (100,000*54%)	54,000.00
Total Cash Flow Year 4	$405,606.47

Answer for Part 1) is $405,606.47 or $405,606

______

Part 2)

The value of year 3 operating cash flow is calculated as follows:

Sales [665,000*(1+8.5%)^2]	782,854.63
Less Expenses (782,854.63*60.75%)	475,584.18
Depreciation [(1,100,000-100,000)/5]	200,000.00
Earnings before Taxes	107,270.44
Less Taxes	22,526.79
Earnings after Taxes	84,743.65
Add Depreciation	200,000.00
Operating Cash Flow for Year 3	$284,743.65

Answer for Part 2) is $284,743.65 or $284,744