Question

1) Use the following information to answer questions a, b, and c. Base Brewery (BB) is considering buying a new goobering machine for $300,000. It will be fully depreciated using MACRS seven-year asset class for depreciation. Shipping and transportation to the factory will cost $45,000. Running the machine will require an immediate increase in working capital (inventory) of $7,000. The machine will increase annual sales revenue by $80,000, and will decrease annual costs by $20,000. The new machine will require a $3,500 additional investment in net working capital (inventory) each year for years 2, 3 and 4. The machine can be sold at the end of the 4th year for 80% of its book value. The tax rate is 35%.

a. Calculate the net initial investment in year zero?

b. Calculate the net cash flow for the 3rd year of new machine’s life.

c. Calculate the terminal cash flow when the company terminates the project and disposes of the machine at the end of the 4th year.

MUST SHOW WORK, thanks!

Answer 1

a. Net Initial Investment :

Cost of buying machine = $300,000

Shipping and transportation cost = $45,000

Increase in working capital = $7,000

Total Net Initial Investment = $300,000+$45,000+$7,000 = $352,000

b. Net cash flow for the 3rd year

Depreciation workings:

Cost of buying machine = $300,000

Shipping and transportation cost = $45,000

Total Cost ot the machine = $345,000 ($300,000+$45,000)

Years	Depreciation rate (as per 7 years MACRS )	Depreciation (Total cost of the machine ($345,000) * Depreciation rate)	Book Value	Workings for Book Value
1	14.29%	49,301	295,700	(Total Cost of the machine - Depreciation for the year)
2	24.49%	84,491	211,209	(Book value as of previous year end - Depreciation for the year)
3	17.49%	60,341	150,869
4	12.49%	43,091	107,778
5	8.93%	30,809	76,970
6	8.92%	30,774	46,196
7	8.93%	30,809	15,387
8	4.46%	15,387	-
Total	100.00%	345,000

Net cash flow for 3rd year:

Increase in annual Sales revenue	80,000	Given in Question
Decrease in annual costs	20,000	Given in Question
Depreciation for year 3	(60,341)	As per above
Earnings before tax	39,660	80000+20000-60341
Tax at 35%	(13,881)	39660*35%
Earnings after tax	25,779	39660-13881
Depreciation for year 3	60,341	As per above
Operating Cash flow for year 3	86,119	25779+60341
Investment in working capital	(3,500)	Given in Question
Net Cash flow for year 3	82,619	86119-3500

Thus, net cash flow for year 3 = $82,619

c. Terminal cash flow at the end of 4th year

Net Sale Value workings:

Book Value at the end of year 4	107,778.00	As per above depreciation table
Sale Value at year 4 (80% of book value)	86,222.40	107778*80%
Loss on sale	(21,555.60)	107778-86222.4
Tax benefit on loss on sale	7,544.46	-21555.6*35%
Net Sale Value	(14,011.14)	-21555.6+7544.46

Recovery of working capital:

It is assumed that the working capital at the end of year 4 will be recovered. Total working capital that will be recovered = $7000 immediately (year 0) + $3500 in year 2 + $3500 in year 3 + $3500 in year 4 = $17,500

Terminal cash flow at the end of year 4:

Increase in annual Sales revenue	80,000	Given in Question
Decrease in annual costs	20,000	Given in Question
Depreciation for year 4	(43,091)	As per above depreciation table
Earnings before tax	56,910	80000+20000-43091
Tax at 35%	(19,918)	56910*35%
Earnings after tax	36,991	56910-19918
Depreciation for year 4	43,091	As per above
Operating Cash flow for year 4	80,082	36991+43091
Investment in working capital	(3,500)	Given in Question
Recovery of net working capital at the end	17,500	Refer above
Net Sale value of the machne	(14,011)	As per above table
Net Cash flow for year 4	80,071	80082-3500+17500-14011

Terminal cash flow at the end of year 4 = Net Sale value of the machne + Recovery of working capital = -14,011+17,500 = $3,489 (on the assumptions working capital will be recovered on sale of machine and end of project)

If the working capital is not to be recovered, terminal cash flow at the end of year 4 will be the net sale value of the machine which is -$14,011.