Question

I am considering purchasing a new golf ball manufacturing machine. The total installed cost of this lovely piece of equipment is $2.2 million. My existing machine cost me $1 million 10 years ago, currently has no book value ($0) & a competitor will pay me $1.2 million for it before taxes but I am subject to a 40% tax rate.

            Because of this new piece of equipment, my annual sales for the next 5 years are expected to be $900,000 more than what I am currently making with my current equipment. Expenses (for the new equipment) will amount to 50% of that increased revenue. I will undergo no change in net working capital & will depreciate the new equipment using a 5 year-recovery period under MACRS. My cost of capital is 11% & there is no terminal cash flow expected.

Determine my initial investment for the new equipment

Determine my Operating cash inflows for the new equipment (consider depreciation in year 6)

What’s my payback period?

What’s the NPV?

What’s the IRR? (to the nearest whole number)

Answer 1

New Golf	0	1	2	3	4	5
MACRS %		20%	32%	19.20%	11.52%	11.52%	5.76%
New	-2,200,000
Old	1,200,000
Sales		900,000	900,000	900,000	900,000	900,000	0
Expenses		-450,000	-450,000	-450,000	-450,000	-450,000	0
Depreciation		-440,000	-704,000	-422,400	-253,440	-253,440	-126,720
EBT		10,000	-254,000	27,600	196,560	196,560	-126,720
Tax (40%)		-4,000	101,600	-11,040	-78,624	-78,624	50,688
Net Income		6,000	-152,400	16,560	117,936	117,936	-76,032
Cash Flows	-1,480,000	446,000	551,600	438,960	371,376	371,376	50,688
Payback	3.12
NPV	$182,586.83
IRR	16.0%

Initial Investment = 2,200,000 - 1,200,000 x (1 - 40%) = $1,480,000

Depreciation = New Investment x MACRS %

Cash Flows = Net Income + Depreciation

Payback Period is the no. of years it takes to recover the initial investment.

Payback Period = 3 + (1,480,000 - 446,000 - 551,600 - 438,960) / 371,376 = 3.12 years

NPV and IRR can be calculated using NPV and IRR function in excel or calculator.