Question

Frito Lay is determining whether to purchase a new piece of equipment, which has a base price of $450,000 and would cost another $34,000 to install. Using the equipment requires a $25,000 investment in additional assets, which will not be sold at the conclusion of this project. This represents the purchase of additional assets required to use the new equipment.

The equipment would be sold after three years for $100,000 and the depreciation allocated to each of those years is as listed below. Upon the sale, the before-tax gain will be $61,000.

                Year 1 = $160,000             Year 2 = $210,000             Year 3 = $75,000

Although it would have no effect on revenues, the equipment should save the firm $180,000 per year in before-tax operating costs (excluding depreciation). Frito Lay’s marginal tax rate is 40%, and its required rate of return is 14%.

Calculate the total initial investment, the total supplemental cash flows for each year 1 - 3, the terminal cash flows, the NPV for the project, and state if the equipment should be purchased in a full sentence.

Below is a template for your work.

Step 1: Initial Investment =

Step 2: Supplemental Cash Flows =

Step 3: Terminal Cash Flows =

Step 4: Net Present Value Analysis =

Step 5: Decision =

Answer 1

Step 1 : Initial Investment = Cost for new equipment + investment in additional assets

= 450000+34000 + 25000 = 509000

Step 2 : Supplemental cash flows

Particulars	Year 1	Year 2	Year 3
Savings per year (A)	$180,000	$180,000	$180,000
Depreciation (B)	$160,000	$210,000	$75,000
Operating Savings (C=A-B)	$20,000	-$30,000	$105,000
Tax (D = C*0.40)	$8,000	-$12,000	$42,000
Depreciation (E)	$160,000	$210,000	$75,000
Cash flows ( F = C - D + E)	$172,000	$192,000	$138,000

Step 3 :

Terminal cash flow = Sale value of equipment - tax on gain on sale of equipment

= 100000 - 0.4*61000

= 100000 - 24400 = $75,600

Step 4 :

Net presenty value analysis

= sum of present value of supplemnetal cash inflows + present value of terminal cash flows - initial investment

Particulars	Year 1	Year 2	Year 3	Total
Savings per year (A)	$180,000	$180,000	$180,000	$540,000
Depreciation (B)	$160,000	$210,000	$75,000	$445,000
Operating Savings (C=A-B)	$20,000	-$30,000	$105,000	$95,000
Tax (D = C*0.40)	$8,000	-$12,000	$42,000	$38,000
Depreciation (E)	$160,000	$210,000	$75,000	$445,000
Cash flows ( F = C - D + E)	$172,000	$192,000	$138,000	$502,000
Discounting Factor	0.877192982	0.769467528	0.674971516	$2
Present value	$150,877.19	$147,737.77	$93,146.07	$391,761.03

= 391761.03 + 75600 / 1.14^3 - 509000

= -$66,211.13

Step 5 : Decision : We should nt buy the equipment as it has a negative NPV.