Question

The Hammerlink Company has been offered an special-purpose metal-cutting machine for $110,000. The machine is expected to have a useful life of eight years with a terminal disposal price of $30,000. Savings in cash operating costs are expected to be $25,000 per year. However, additional working capital is needed to keep the machine running efficiently and without stoppages. Working capital includes such items as filters, lubricants, bearings, abrasives, flexible exhaust pipes, and belts. These items must continually be replaced so that an investment of $8,000 must be maintained in them at all time, but this investment is fully recoverable (will be Ucashed in") at the end of the useful life. Hammerlink's required rate of return is 14%. 4. You have the authority to make the purchase decision. Why might you be reluctant to base your decision on the DCF model?

Answer 1

Calculation of Net Present Value
Deprecation Calculation
Cost of the special purpose metal cutting machine				$110,000
Expected Life in Yrs				8
Terminal Salvage Value				$30,000
Therefore Depreciation				($110000-$30000)/8
				$10,000
Savings in Cash operating costs			$25,000
Less Depreciation			$10,000
Savings in Cash Operating cost after dep			$15,000
Add Back : Depreciation			$10,000
Net CFAT to be considered for calculation(Net Cash Flow)			$25,000
Item	Years	Amount of Cash Flow	14% PV Factor	PV of cash flow
Net cash Flow	1 to 8	$25,000	4.638864	$927772.8
Residual Value of Equipment	8	$30,000	0.350559	$10,516.77
Release of Working Capital	8	$8,000	0.350559	$2,804.47
Cost of Special Purpose machine	0	$110,000	1	-110000
working capital required	0	$8,000	1	-8000
Net Present Value				$823094
Since the Net Present value is positive the Hammerlink Company can go and make the
purchase of Special Purpose Machine
A DCF analysis also analysis the present value of an asset on the value of money it is expected to produce in the future.
But the main assumption is that the asset will be expected to generate cash flow in the required time frame .It can be prone
to errors for this purpose.Its very sensitive to changes in assumptions.It looks at the company valuation in isolation.Also when
valuing the asset or company valuation we have to look at the various relative valuations of the competitors in the market.The
terminal value of an asset is hard to estimate and represents and large portion of the total value and it is quite challening
to estimate the WACC.