Question

The Madison Prefabricated Buildings Co. is considering adding a new line to its product mix. Marcy Mulholland is to conduct a capital budgeting analysis on the project. The production line would be set up in unused space in Madison's main plant. The space could be leased out at $25,000 per year. The machinery's invoice price is approximately $200,000; $10,000 in shipping charges would be required; and it would cost $30,000 to install the machinery. The firm's inventories would have to be increased by $25,000 to handle the new line, but its accounts payable would rise by $5,000. The machinery has an economic life of 4 years, and qualifies as a MACRS 3-year asset. The machinery is expected to have a salvage value of $25,000 after 4 years. The new line would generate $125,000 in additional revenues in each of the next 4 years. The firm's marginal tax rate is 40% and its required return is 10 percent.

a.Construct the cash flows for each year by modifying an income statement. Be able to describe why you treated each cash flow as you did.

b.If the new product line decreases sales of the firm's other lines by $50,000 per year, should this information be included in the analysis? If so, how would Ms. Mulholland do it?

c.Determine whether the machine should be purchased. Explain your decision.

d.How much taxes did you save by having depreciation expense?

Answer 1

The Madison Prefabricated Buildings Co.
Capital Investment Analysis:
Total Capitalization of Machine
Machine purchase cost	200,000
Shipping charge	10,000
Installation cost	30,000
Total Capitalizations cost	240,000

Annual Depreciation :
MACRS 3 year depreciation	Year 0	Year 1	Year 2	Year 3	Year 4	Total
MACRS Rate		33.33%	44.45%	14.81%	7.41%
Annual Depreciation :		79,992	106,680	35,544	17,784
Tax Rate =40%
Annual Depreciation Tax savings =Depreciation expense *40%		31,997	42,672	14,218	7,114	96,000

So Total Tax saved from depreciation =$96,000	Ans d
Salvage Value after 4 years	25,000
Tax on Salvage @40%	10,000
After Tax salvage	15,000
Increase in Inventory	25,000
Less Increase in AP	(5,000)
Net Increase in Working Capital	20,000
Increased Revenue from new machine	125,000
Less Tax @40%	50,000
After Tax increase in Revenue	75,000

	Ans a.
	Cash flow from Project :	Year 0	Year 1	Year 2	Year 3	Year 4
	Initial Investment
	Machine cost	(240,000)
	Net Investment in WC	(20,000)
	Opportunity Loss of Lease Rental	(25,000)	(25,000)	(25,000)	(25,000)	(25,000)
a	Initial Investment +Lease rental Opp Loss	(285,000)	(25,000)	(25,000)	(25,000)	(25,000)
	Cash flow from Operations
	After Tax incremental Revenue		75,000	75,000	75,000	75,000
	Depreciation Tax savings		31,997	42,672	14,218	7,114
b	Total Cash flow from Operations		106,997	117,672	89,218	82,114
	Terminal Cash flow
	After Tax salvage					15,000
	Recovery of NWC					20,000
c	Total Terminal Cash flow					35,000
d	Free Cash flow from the New Line =a+b+c	(285,000)	81,997	92,672	64,218	92,114

Ans b.
If new machine line reduces revenue of other product
lines , that loss need to be considered as opportunity
cost of lost sale.
Here the Annual loss of sale of other product line is =	(50,000)
Annual incremental revenue from new line =	125,000
Net Incremental sales =	75,000
Less Tax 40%	30,000
Net Incremental After Tax revenue increase/year	45,000
We have to change the incremental after tax annual
revenue to 45,000 from 75,000 in such case.

And c.
Considering the sales loss and reworking cash flow for NPV

	Ans a.
	Cash flow from Project :	Year 0	Year 1	Year 2	Year 3	Year 4
	Initial Investment
	Machine cost	(240,000)
	Net Investment in WC	(20,000)
	Opportunity Loss of Lease Rental	(25,000)	(25,000)	(25,000)	(25,000)	(25,000)
a	Initial Investment +Lease rental Opp Loss	(285,000)	(25,000)	(25,000)	(25,000)	(25,000)
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