Question

FLAWLESS Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $635,000 is estimated to result in $211,000 in annual pretax cost savings. The press falls in the MACRS 5-year class, and it will have a salvage value at the end of the project of $98,000. The MACRS rates are 0.2, 0.32, 0.192, 0.1152, 0.1152, and 0.0576 for Years 1 to 6, respectively. The press also requires an incremental $3,600 in inventory for each of the four years of the project. FLAWLESS must also invest $24,000 at the outset for spare parts inventory. Both types of inventory will return to zero when the project ends. The shop's tax rate is 23 percent and its discount rate is 12 percent.  Should FLAWLESS buy and install the machine press? Why or why not?

Answer 1

Computation of Annual Cash flows:

S.No	Particulars	Year 1	Year 2	Year 3	Year 4
A	Annual Pre tax Cost savings	$211,000	$211,000	$211,000	$211,000
B	Depreciation	$127,000	$203,200	$121,920	$73,152
C	Profit before Tax(A-B)	$84,000	$7,800	$89,080	$137,848
D	Tax @ 23%	$19,320.00	$1,794.00	$20,488.40	$31,705.04
E	Profit After Tax(C-D)	$64,680.00	$6,006.00	$68,591.60	$106,142.96
F	Annual Cash flow( B+E)	$191,680.00	$209,206.00	$190,511.60	$179,294.96

Computation of Depreciation Amount

Year	Applicable rate	Depreciation Calculation
1	0.2	$ 635000*0.2= $ 127000
2	0.32	$ 635000*0.32=$ 203200
3	0.192	$ 635000*0.192=$ 121920
4	0.1152	$ 635000*0.1152= $ 73152
	Total	$525,272.00

Working Note 1:Computation of Present Value of the Cash inflows

Year	Amount	Disc @ 12%	Discounted Cash flows
1	$191,680.00	0.8929	$171,142.86
2	$209,206.00	0.7972	$166,777.74
3	$190,511.60	0.7118	$135,602.39
4	$179,294.96	0.6355	$113,945.19
	Total		$587,468.18

Working Note 2:Computation of Net Working Capital used

Year	Amount	Disc @ 12%	Discounted Cash flows
0	$24,000	1	$24,000
1	$3,600	0.8929	$3,214
2	$3,600	0.7972	$2,870
3	$3,600	0.7118	$2,562
4	$3,600	0.6355	$2,288
Total	$38,400		$34,934

Recovery of Working Capital at the end of the Project $ 38400/( 1.12) ^4

= $ 38400*0.6355

= $ 24403.20

Net Working Capital used = $ 34934-$ 24403.20= $ 10530.8

Working Note 3:Computation of Present Value of salvage Value

Carrying Value of the Machine = Original Cost - Accumulated Depreciation.

= $ 635000-$ 525272

= $ 109728

Equipment is sold for $ 98000

Loss on sale of Machinary = $ 109728- $ 98000= $ 11728

Tax savings on loss = $ 11728*23% = $ 2697.44

Present value of tax savings $ 2697.44/( 1.12)^4

= $ 2697.44*0.6355

= $ 1714.22

Computation of Net Present Value

Particulars	Amount
Present value of Future Cash inflows( wn:1)	$587,468.18
Tax savings on salvage value( wn :3)	$1,714.22
Initial Outlay	($635,000)
Net Working Capital used( wn:2)	($10,530.80)
Total	($56,348.40)

Since Net Present value is Negitive, we should not accept the project.Flawless is not advisable to buy the machine

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