Question

Murray’s Machine Shop is considering a five year project to improve its production efficiency. Buying a new machine press for $850,000 is expected to result in annual pre-tax cost saving of $310,000. No additional sales are expected from this project. The machine press will be depreciated straight-line to zero over its five year life. After that it is expected to be obsolete and therefore worthless. The company will be able to reduce net working capital (NWC) by $75,000 at the beginning of the project. NWC will revert back to its original level at the end of project. The company’s hurdle rate is 15%. The tax rate is 21%. a. List all the assumption of the project. b. Calculate each year’s depreciation and ending book values. c. Prepare pro forma income statements for the five years of the project’s life. d. Calculate the changes in net working capital. e.Calculate the project’s operating cash flows. f. Calculate the project’s net net cash flows. g. Calculate the project’s net present value (NPV) h. Calculate the project’s internal rate of return (IRR) i. Should the company purchase the new machine press? Why or why not? (Must be done on a spreadsheet using Excel formulas only)

Answer 1

Answer a
Assumptions of the project
- Zero salvage value of machine at the end of project.
- No additional sales
- tax rate and hurdle rate be 21% and 15% respectively for all years
Answer b
Calculation of depreciation and book values
Year	Depreciation	Book Values
0	0	850000
1	170000	680000
2	170000	510000
3	170000	340000
4	170000	170000
5	170000	0
Depreciation per year using straight line method = (Cost - salvage value)/Useful life
Depreciation per year using straight line method = ($850000-$0)/5 years = $1,70,000
Answer c
Proforma Income statement
Year		1	2	3	4	5
Cost savings		310000	310000	310000	310000	310000
Less : Depreciation		170000	170000	170000	170000	170000
Profit before tax		140000	140000	140000	140000	140000
Less : Tax @ 21%		29400	29400	29400	29400	29400
Increase in Net Income		110600	110600	110600	110600	110600
Answer d
Calculation of changes in working capital
Year		0	1	2	3	4	5
Changes in working capital		75000					-75000
Answer e
Calculation of project's operating cash flow
Year		1	2	3	4	5
Increase in net income		110600	110600	110600	110600	110600
Add : Depreciation		170000	170000	170000	170000	170000
Project's Operating cash flow		280600	280600	280600	280600	280600
Answer f
Calculation of project's net cash flow
Year		0	1	2	3	4	5
Initial Investment		-850000
Changes in working capital		75000					-75000
Operating cash flow			280600	280600	280600	280600	280600
Net Cash flows		-775000	280600	280600	280600	280600	205600
Answer g
Calculation of project’s net present value (NPV)
Year		0	1	2	3	4	5	NPV
Net Cash flows		-775000	280600	280600	280600	280600	205600
x Discount factor @ 15%		1	0.869565	0.756144	0.657516	0.571753	0.497177
Present Values		-775000	244000	212173.9	184499.1	160434	102219.5	128,326.47
NPV of the project =		128,326.47
Answer h
Calculation of IRR of the project
At IRR , the NPV of the project is equal to zero.
Year		0	1	2	3	4	5	IRR
Net Cash flows		-775000	280600	280600	280600	280600	205600	22.05%
IRR of the project =		22.05%
Answer i
Company should purchase the new machine press as it has positive NPV and IRR is greater than hurdle rate.