Question

The Cosmo K Manufacturing Group currently has sales of $1,400,000 per year. It is considering the addition of a new office machine, which will not result in any new sales but will save the company $105,500 before taxes per year over its 5-year useful life. The machine will cost $300,000 plus another $12,000 for installation. The new asset will be depreciated using a modified accelerated cost recovery system (MACRS) 5-year class life. It will be sold for $25,000 at the end of 5 years. Additional inventory of $11,000 will be required for parts and maintenance of the new machine. The company evaluates all projects at this risk level using an 11.99% required rate of return. The tax rate is expected to be 35% for the next decade.

Tasks: Answer the following questions:

What is the total investment in the new machine at time = 0 (T = 0)?

What are the net cash flows in each of the 5 years of operation?

What are the terminal cash flows from the sale of the asset at the end of 5 years?

What is the NPV of the investment?

What is the IRR of the investment?

What is the payback period for the investment?

What is the profitability index for the investment?

According to the decision rules for the NPV and those for the IRR, is the project acceptable?

Is there a conflict between the two decision methods? If so, what would you use to make a recommendation?

What are the pros and cons of the NPV and the IRR? Explain your answers.

Please show the excel spread sheet calculations.

Answer 1

cost of machine		-300000
installation		-12000
working capital		-11000
cash outflow at year 0		-323000
Year	0	1	2	3	4	5		cost of machine	MACRS rate	annual depreication
cash outflow at year 0	-323000							312000	20%	62400
annual savings		105000	105000	105000	105000	105000		312000	32%	99840
less depreciation		62400	99840	59904	35942.4	35942.4		312000	19.20%	59904
less tax -35% (savings-depreciation)*tax rate		14910	1806	15783.6	24170.16	24170.16		312000	11.52%	35942.4
after tax savings		27690	3354	29312.4	44887.44	44887.44		312000	11.52%	35942.4
net operating annual savings		90090	103194	89216.4	80829.84	80829.84		accumulated depreciation		294028.8
after tax sales value						22539.92		book value of machine = 312000-294028.8		17971.2
recovery of working capital						11000		selling price of machine at year 0		25000
net operating annual savings		90090	103194	89216.4	80829.84	114369.8				17971.2
present value of cash flow at 11.99% = cash flow/(1+r)^n r= 11.99%	-323000	80444.68	82280.32	63519.48	51387.17	64925.45		gain on sale of machine	25000-17971.2	7028.8
NPV= sum of present value of cash flow	19557.11							tax on gain on sale of machine	7028.8*35%	2460.08
IRR =Using IRR function in MS excel	2.12%							terminal cash flow = after tax sale price	25000-2460.08	22539.92
PI =1+(NPV/initial investment)	1+(19557.11/323000)	1.060548
Year	net operating cash flow	cumulative cash flow	year
0	-323000
1	80444.68	80444.68
2	82280.32	162725
3	63519.48	226244.5
4	51387.17	277631.7
5	64925.45	45368.34	amount to be recoverd in year 5 = 45368.34/64925.45 =.689
So pay back period is	year before the final recovery +(amount to be recovered in year/cash flow of final year)	4+(45368.34/64925.45)	4.70
For NPV project is acceptable while for IRR it is rejected
Yes there is conflict between IRR and NPV so it is better to go with NPV
IRR is based on some unrealistic assumption while NPV is a better measure of decision making