Question

Question 2

You must evaluate a proposal to buy a new milling machine with purchase price of $150,000. The machine will be depreciated to zero value over the 4 years using prime cost (straight line) method. The machine would be sold after 4 years for $70,000.

Inventory will increase by $17,000 and account payables will rise by $7,500. All other working capital components will stay the same, so the change in net working capital is $9,500. The managers expect to fully recover the working capital of $9,500 at the end of the project (year 4).

The pretax labor costs would decline by $50,000 per year.

Below shows the forecasted sales revenues, variable cost and fixed cost.

	Year 1	Year 2	Year 3	Year 4
Sales quantity (units)	2,500	3,000	3,500	4,000
Selling price per unit	$3	$3.1	$3.2	$3.3
Fixed cost of production (per year)	$2,000	$2,100	$2,200	$2,300
Variable cost of production (per unit)	$1.1	$1.2	$1.25	$1.35

The marginal tax rate is 35% and the discount rate is 10.5%.

1. What is the net present value (NPV) of the proposal?                                

   

2. Advise should the project be accepted based on your answer in part (i)?     

Answer 1

Calculation of depreciation:
Purchase price of machine	$     150,000
Life in years	4
Depreciation per year	$       37,500
Tax rate	35%
Tax shield on depreciation	$       13,125

Since, depreciation is a non cash item, so we need to consider only the tax benefit on depreciation expense

Calculation of tax on sale of machine
Purchase price of machine	$     150,000
Life in years	4
Depreciation for 4 years	$     150,000
Book value after 4 years	$               -
Sale value	$       70,000
Profit on sale	$       70,000
Tax rate	35%
Tax on profit	$       24,500

Calculation of NPV

	Year 0	Year 1	Year 2	Year 3	Year 4
Purchase price of machine	$    (150,000)
Sales quantity (units)		2,500	3,000	3,500	4,000
Selling price per unit		$        3.00	$        3.10	$        3.20	$        3.30
Variable cost of production (per unit)		$        1.10	$        1.20	$        1.25	$        1.35
Total sales		$      7,500	$      9,300	$    11,200	$    13,200
Total variable cost		$    (2,750)	$    (3,600)	$    (4,375)	$    (5,400)
Fixed cost of production (per year)		$    (2,000)	$    (2,100)	$    (2,200)	$    (2,300)
Savings in labor costs		$    50,000	$    50,000	$    50,000	$    50,000
Change in operating income		$    52,750	$    53,600	$    54,625	$    55,500
Tax @ 35%		$ (18,463)	$ (18,760)	$ (19,119)	$ (19,425)
After tax cash flows	$    (150,000)	$    34,288	$    34,840	$    35,506	$    36,075
Inventory Increase	$      (17,000)				$    17,000
Accounts payable	$         7,500				$    (7,500)
Depreciation tax shield		$    13,125	$    13,125	$    13,125	$    13,125
Sale value after 4 years					$    70,000
Tax on profit of sale of machine					$ (24,500)
Total cash flows	$    (159,500)	$    47,413	$    47,965	$    48,631	$ 104,200
Discounting factor @10.5%	1.0000	0.9050	0.8190	0.7412	0.6707
Present values	$    (159,500)	$    42,907	$    39,283	$    36,044	$    69,891
Net present value (NPV)	$       28,624

Note:Decline in labor costs is considered as inflow.

Since the net present value of the proposal is postive, so the proposal can be accepted.