Question

Cowboys Copies, Inc., wants to upgrade its copy machines. Its last update was 2 years ago, when it spent $1,150 on equipment with an assumed life of 5 years and. The firm uses MACRS depreciation. The old equipment can be sold today for $800. A new system can be installed today for $1,500. This will have a 3 year life and will be depreciated under MACRS 3 year schedule. At the end of 3 years, the new equipment will be worthless (therefore, market value of zero).
The company projects unit sales associated with the new equipment as follows:

Year	Sales (in Units)
1	72
2	80
3	64
Thereafter	0

Investment in net working capital will be 20 percent of the sales for the following year.
Therefore, total net working capital for year 0 would be 20 percent of the sales in year 1 and for year 1, you will need total net working capital amounting to 20 percent of the sales for year 2 in dollar values (not in units). The production costs are $15 per unit, and the units are priced at $40 each. The firm is in the 40 percent marginal tax bracket and required rate of return is 12%.

MACRS Schedule

Year	3 year	5 year
1	33.33	20.00
2	44.45	32.00
3	14.81	19.20
4	7.41	11.52
5		11.52
6		5.76

a. What are the operating cash flows for Years 1 to 3?

b. what are the cash flows from net working capital for years 1 to 3?

c. what is the cash flow from the sales of the od equipment at year 3?

d. what is the NPV of this project? would you accept this project?

e. what is the IRR of this project? would you accept this project?

Answer 1

Depreciation Schedule as per Marcs and Tax Savings per year Schedule:

Year Depreciation Percentage Initial Value Depreciation Expense Tax Savings 1 33.33% 1500 499.95 166.63 2 44.45% 1500 666.75 296.37 3 14.81% 1500 222.15 32.90

a) b) c) in a single table

Operating Cash Flows for year 1 to 3

Year Sales (in Units) Selling Price Revenue Production Cost (per unit) Production Cost Working Capital EBIT Tax Tax Savings Net Income 1 72 40 2880 15 1080 576 1224 489.6 166.63 901.03 2 80 40 3200 15 1200 640 1360 544 296.37 1112.37 3 64 40 2560 15 960 512 1088 435.2 32.90 685.70

Notes:

• Working Capital is 20% of Revenue
• Tax is 40 % of EBIT
• EBIT = Revenue - Production Cost - Working Capital
• Tax Savings are as per schedule of MARCS Depreciation Schedule.

d)

NPV = 901.03 / ( 1.12)¹ + 1112.37 / ( 1.12)² + 685.7 / (1.12)³ - 1500 + 800

= $ 1,302.83

Note: The sale value of old equipment has been added back to intial investment

NPV > 0. So, I will accept this project.

e) IRR is calculated using Excel or Financial Calculator. Excel function is IRR( ).

NPV, if set to 0 will give the value of IRR which is used to discount the present value.

IRR = 121%.

IRR > Required Rate of Return or Cost of Capital.

Hence, we will accept the project.