Question

Example 6:

Technology Tools

is evaluating the purchase of a new type of technology that would cost $1.5 million to

purchase, ship, and install. Still, investment in this machine is expected to increase sales revenues by $400,000, and

reduce operating expenses before depreciation and taxes by $125,000 per year. To operate this machine properly,

workers would have to go through a brief training session that would cost $14,000 on an after tax basis. Also, because

this machine is extremely efficient, its purchase would necessitate an increase in inventories of $80,000, which will be

partially offset by a $25,000 increase in accounts payable. This machine has an expected life of 10 years, after which

the after tax market (salvage) value of the machine will just equal the cost to remove and sell the equipment. Assume

simplified straight-line depreciation and that this machine is being depreciated down to zero. The firm has a 40%

marginal tax rate, and a cost of capital for this very risk project is 22.0% for this type of investment.

a.

What is the initial cost 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 (i.e., what is the annual after-tax cash flow in Year 10 plus any

additional cash flows associated with termination of the project)?

Answer 1

a. Initial cost associated with projecy is $ 1,569,000

Year	Purchase of Equipment	Sales revenue	Reduction in Operating expenses	Increase in Inventory	Increase in Accounts payable	Depreciation	Change in Profit before tax	Taxes	Training Cost	Annual cash Flow
0	(1,500,000)			-80000	25000				-14000	(1,569,000)

b. Annual cash flow associated with the project for the year 1 to 9 is as below:-

Year	Purchase of Equipment	Sales revenue	Reduction in Operating expenses	Increase in Inventory	Increase in Accounts payable	Depreciation	Change in Profit before tax	Taxes	Training Cost	Annual cash Flow
1		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000
2		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000
3		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000
4		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000
5		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000
6		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000
7		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000
8		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000
9		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000

c. Terminal cash flow in year 10

Year	Purchase of Equipment	Sales revenue	Reduction in Operating expenses	Increase in Inventory	Increase in Accounts payable	Depreciation	Change in Profit before tax	Taxes	Training Cost	Annual cash Flow
10		400,000	125,000			(150,000)	375,000	(150,000.0)		375,000

There will nnot be any impact of project termination cost as salvage value is equal to cost to remove the equipment.

NPV of the project at interest rate 22% is ($ 80,169)