Question

Harriman Manufacturing Co. is evaluating the purchase of a new forklift. The quoted price is $50,000, and it would cost Harriman another $10,000 for related capital costs such as transportation and equipment modification for special use. The total investment would fall into MACRS three year class with depreciation rates being applied to the full capitalized costs, not deducting salvage, at 33%, 45%, 15% and 7% in years 1-4, respectively. Harriman expects that the equipment would be sold in the fourth year, after three years of use, for a price of $25,000. During the three year operating period spare parts inventory would increase by $3,000 to maintain the equipment, but non-interest bearing accounts payable would increase by $1,000. Although the equipment is not expected to increase the firm's revenue, it is expected to save it $20,000 in before tax labor operating costs annually. (Problem set up is important.) (Clue: When do you need spare parts?) Harriman's tax rate is 40%.

a. Calculate the expected net cash outlay at the beginning of the first year.

b. Estimate the net operating cash flows in years 1, 2 and 3, and assume they occur at the end of each year.

c. What is the dollar value of the net cash terminal value in the fourth year?

d. If Harriman's weighted average cost of capital is 10%, what are the investment's

i. Net Present Value?

ii. Internal Rate of Return?

iii. Simple Payback Period?

iv. Should the investment be made? Why or why not?

Show the set up or calculator entries for all calculations.

Answer 1

		0	1	2	3	4
	Savings in before tax labor costs		$        20,000	$         20,000	$       20,000	$                  -
	Depreciation		$        19,800	$         27,000	$          9,000	$           4,200	$      60,000
	Incremental NOI		$              200	$         -7,000	$       11,000	$         -4,200
	Tax at 40%		$                 80	$         -2,800	$          4,400	$         -1,680
	Incremental NOPAT		$              120	$         -4,200	$          6,600	$         -2,520
	Incremental NOI		$        19,800	$         27,000	$          9,000	$           4,200
	Incremental OCF		$        19,920	$         22,800	$       15,600	$           1,680
	Capital expenditure	$           60,000
	Change in NWC	$              2,000			$        -2,000
	After tax salvage value = 25000*(1-40%) =					$        15,000
	Net after tax cash flows	$          -62,000	$        19,920	$         22,800	$       17,600	$        16,680
	Interest factor for 10%	1.00000	0.90909	0.82645	0.75131	0.68301
	PW	$          -62,000	$        18,109	$         18,843	$       13,223	$        11,393
	NPW	$                -432
	ANSWERS:
a]	Expected net cash outlay at the beginning = 60000+2000 =	$           62,000
b]	Net cash outflows for years 1,2 & 3		$        18,109	$         18,843	$       13,223
c}	Dollar value of net cash terminal value					$        16,680
d]
i]	NPV [See workings above]	$                -432
ii]	IRR is that discount rate which gives 0 NPV. It has to be found out by trial and error by varying the discount rate to get
	0 NPV. It is done in the above table:
	Discounting with 9%:
	PVIF at 9%	1	0.91743	0.84168	0.77218	0.70843
	PV at 9%	$          -62,000	$        18,275	$         19,190	$       13,590	$        11,817
	NPV	$                 872
	NPV at 10% is -432 and NPV at 9% is 872. So, IRR lies between 9% and 10%.
	By simple interpolation, IRR = 9%+1%*872/(872+432) =	9.67%
iii]	Simple payback period:
	Cumulative cash flow	$          -62,000	$       -42,080	$       -19,280	$        -1,680	$        15,000
	Payback period = 3+1680/16680 =	3.10	Years
iv]	The investment should not be made as NPV is negative [Due to which IRR<WACC]