Question

(New project analysis​) Garcia's Truckin' Inc. is considering the purchase of a new production machine for $200,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $50,000 per year. To operate the machine​ properly, workers would have to go through a brief training session that would cost $5,000 after taxes. It would cost $5,000 to install the machine properly.​ Also, because this machine is extremely​ efficient, its purchase would necessitate an increase in inventory of $20,000. This machine has an expected life of 10 years, after which it will have no salvage value.​ Finally, to purchase the new​ machine, it appears that the firm would have to borrow​ $100,000 at 8 percent interest from its local​ bank, resulting in additional interest payments of $8,000 per year. Assume simplified​ straight-line depreciation and that the machine is being depreciated down to​ zero, a 34 percent marginal tax​ rate, and a required rate of return of 10 percent.

a. What is the initial outlay associated with this​ project?

b. What are the annual​ after-tax cash flows associated with this project for years 1 through​ 9?

c. What is the terminal cash flow in year 10 (what is the annual​ after-tax cash flow in year 10 plus any additional cash flows associated with the termination of the​ project)?

d. Should the machine be​ purchased?

Answer 1

1) Calculation of Inital Cash Outlay

S.No	Particulars	Amount
1	Cost of the Machine	200,000
2	Installation Cost	5,000
3	Training Cost	5,000
4	Initial Cash Outlay	210,000
5	Increase in Inventory / Working Capital ( Considering Investment in WC take part at the Beginning of the year )	20,000
6	Total Cash Outflow at the Beginning	230,000

2) Annual After Tax Cash Flows

S.No	Particulars	Amount
1	Increase in EBIT	50,000
2	Additional Interest Payment	(8,000)
3	Depreciation	(20,000)
4	Earnings before Tax	22,000
5	Tax @ 34%	(7,280)
6	Earnings After Tax	14,520
7	Add: Non Cash Flow Items ( Dep )	20,000
8	Annual after tax cash Flow through Year 1 to 9	34,520

3) Terminal Cash Flow at Year 10

i) Annual after tax Cash Flow - 34,520

ii) Decrease in Inventory / WC - 20,000

iii) Terminal Cash Flow - 54,520

4) Calculation of NPV

Year	Particulars	Cash Flow	PVF @ 10%	Discounted Cash Flow
0	Initial Cash Outlay	2,30,000	1	(230,000)
1-9	Annual after Tax Cash Flows	34,520	5.7590	198,801
10	Terminal Cash Flow	54,520	0.3855	21,017
	Net Present Value			(10,092)

Sinnce the NPV is negative, the machine should not be purchased.

( Note: we can also use PVF @ 6.6%, the final Answer won't differ )