Question

CheapO is evaluating the purchase of a new crane system for $1,000,000. If they purchase this system, revenues will increase by $250,000 and associated expenses will increase by 65% of revenues. The installation of the system is expected to cost $100,000 and require training of another $25,000. Because of the increase in business expected by the purchase of the system Accounts Receivable is expected to increase by $30,000. The company expects to use this machine for 10 years after which it will have no salvage value. Assume simplified straight-line depreciation and that this machine has been depreciated down to zero, a 20% marginal tax rate, and a required rate of return of the WACC you previously calculated.

WACC = 8.316% or 8.32%

What is the initial outlay associated with this project?

What are the annual after-tax cash flows associated with this project for years 1 through 9?

What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project)?

What is the project’s NPR and IRR?

What would be your decision about acquiring this asset? Why?

Of the 4 types of capital budgeting techniques described in this course, which one do you prefer? Explain.

Answer 1

1)	INITIAL OUTLAY:
	Cost of the new crane system	$   10,00,000
	Cost of installation	$     1,00,000
	Cost of training (net of tax = 25000*80%)	$         20,000
	Increase in NWC	$         30,000
	Total initial outlay	$   11,50,000
2)	ANNUAL AFTER TAX CASH FLOWS:
	Increase in revenues	$     2,50,000
	Increase in expenses(65% of revenues)	$     1,62,500
	Depreciation (1100000/10)	$     1,10,000
	Incremental NOI	$       -22,500
	Tax at 20%	$          -4,500
	NOPAT	$       -18,000
	Add: Depreciation	$     1,10,000
	After tax annual cash inflows	$         92,000
3)	TERMINAL CASH FLOW IN YEAR 10:
	Release of NWC	$         30,000
	Terminal cash flow in year 10	$         30,000
4)	NPV:
	NPV = 92000*PVIFA(8.32,10)+30000*PVIF(8.32,10)-1150000 = 92000*6.6143+30000*0.4497-1150000 =	$    -5,27,993
5)	IRR is that discount rate for which NPV = 0, which means
	NPV = 92000*PVIFA(irr,10)+30000*PVIF(irr,10)-1150000 = 0
	or
	92000*PVIFA(irr,10)+30000*PVIF(irr,10)=1150000
	The value of irr is to be found out by trial and error
	or using an online financial calculator.
	IRR using an online calculator = -3.05%
6)	As the NPV and IRR are negative the asset should not be acquired.
7)	NPV is the preferred method, as it gives the absolute value of the
	addition to shareholders' wealth, in case the project is undertaken.