Question

XYZ company is considering a new machine that costs $250,000 and would reduce pre-tax manufacturing costs by $90,000 annually. XYZ would use the 3-year MACRS method to depreciate the machine, and management thinks the machine would have a value of $23,000 at the end of its 5-year operating life. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The net operating Working capital would increase by $25,000 initially, but it would be recovered at the end of the project's 5-year life. XYZ's marginal tax rate is 40-percent, and a 10 percent WACC is appropriate for the project.

a) Calculate the projects NPV, IRR, and Payback.

b) Assume management is unsure about the $90,000 cost-savings-this figure could deviate by as much as plus or minus 20%. What would have the NPV be under each of these situations?

Write it out please or show how to do on the calculator, not excel please

Answer 1

a.   0         1         2         3         4         5   

Initial investment    ($250,000)

Net working capital    (25,000)

Cost savings                                 $90,000   $  90,000     $90,000     $90,000     $90,000

Depreciationa                                  82,500     112,500       37,500       17,500                0

Oper. inc. before taxes                 $  7,500  ($  22,500)    $52,500     $72,500     $90,000

Taxes (40%)                                     3,000        (9,000)      21,000       29,000       36,000

Oper. Inc. (AT)                            $  4,500  ($  13,500)    $31,500     $43,500     $54,000

Add: Depreciation                         82,500     112,500       37,500       17,500                0

Oper. CF                                      $87,000   $  99,000     $69,000     $61,000     $54,000

Return of NWC $25,000

Sale of Machine 23,000

Tax on sale (40%)                                                                                                    (9,200)

Project cash flows   ($275,000)    $87,000   $  99,000     $69,000     $61,000     $92,800

NPV = $37,035.13

IRR = 15.30%

MIRR = 12.81%

Payback = 3.33 years

Notes:

a Depreciation Schedule, Basis = $250,000

                                                                               MACRS Rate

                                                                                   × Basis =

              Year        Beg. Bk. Value MACRS Rate  Depreciation     Ending BV

                 1              $250,000               0.33            $  82,500           $167,500

                 2                167,500               0.45              112,500               55,000

                 3                  55,000               0.15                37,500               17,500

                 4                  17,500               0.07                 17,500                        0

$250,000

b.               If savings increase by 20%, then savings will be (1.2)($90,000) = $108,000.

If savings decrease by 20%, then savings will be (0.8)($90,000) = $72,000.

(1)     Savings increase by 20%:

                                         0                1                2                3                4                5     

Initial investment    ($250,000)

Net working capital    (25,000)

Cost savings                               $108,000   $108,000   $108,000   $108,000   $108,000

Depreciation                                   82,500     112,500       37,500       17,500                   0

Oper. inc. before taxes               $  25,500  ($    4,500)  $  70,500   $  90,500   $108,000

Taxes (40%)                                   10,200        (1,800)      28,200       36,200       43,200

Oper. Inc. (AT)                          $  15,300  ($    2,700)  $  42,300   $  54,300   $  64,800

Add: Depreciation                         82,500     112,500       37,500       17,500                   0

Oper. CF                                    $  97,800   $109,800   $  79,800   $  71,800   $  64,800

Return of NWC                                                                                                 $  25,000

Sale of Machine                                                                                                     23,000

Tax on sale (40%)                                                                                                        (9,200)

Project cash flows   ($275,000)  $  97,800   $109,800   $  79,800   $  71,800   $103,600

NPV = $77,975.63

(2)     Savings decrease by 20%:

                                         0                1                2                3                4                5     

Initial investment    ($250,000)

Net working capital    (25,000)

Cost savings                                 $72,000   $  72,000     $72,000     $72,000     $72,000

Depreciation                                   82,500     112,500       37,500       17,500                0

Oper. inc. before taxes                ($10,500) ($  40,500)    $34,500     $54,500     $72,000

Taxes (40%)                                    (4,200)    (16,200)      13,800       21,800       28,800

Oper. Inc. (AT)                           ($  6,300) ($  24,300)    $20,700     $32,700     $43,200

Add: Depreciation                         82,500     112,500       37,500       17,500                0

Oper. CF                                      $76,200   $  88,200     $58,200     $50,200     $43,200

Return of NWC                                                                                                   $25,000

Sale of Machine                                                                                                     23,000

Tax on sale (40%)                                                                                                     (9,200)

Project cash flows   ($275,000)    $76,200   $  88,200     $58,200     $50,200     $82,000

NPV = -$3,905.37