Question

2. Smith Corp. is considering whether to expand widget production. This would require the purchase of a new widget-producing machine at a cost of $5,400,000. The machine would produce 450,000 widgets per year during its useful life of three years, and would be depreciated for tax purposes at a rate of $1,800,000 per year. The machine would have a salvage value of $500,000. Expanding widget production would also require the use of a building that could otherwise be leased for $500,000 per year. Working capital would be 12% of the next year’s sales. Widget prices are $20 and are expected to remain stable. The materials and labor required to produce a widget cost $12, and these costs are also expected to remain stable. The tax rate is 30%. The discount rate is 8% per year.

(a) Compute the incremental free cash flow resulting from the purchase of a widget machine on a year-by-year basis.  

(b) What is the NPV of the widget machine?

Answer 1