Question

A toy manufacturer has two options to acquire electronic component for existing products Option one: pay a sub-contractor $600,000 (before tax) a year. Option two: produce the component by itself. If the firm chooses to produce, the production cost would be $300,000 a year, and the machine will cost $150,000. Also a working capital of $25,000 is required. The working capital will be recovered when the production ends. Assume the production will last for four years. The machine can be depreciated by using a four-year straight line depreciation method or by using three-year MACRS method. The three-year MACRS method has the corresponding annual depreciation rate of 33.33%, 44.45%, 14.81% and 7.41% for the first four years. The machine has no resale value after four years. If the tax rate is 35% and the cost of capital is 15%. Assume all operating cash flows occur at the end of the year. Calculate the NPV for Option two if using MACRS for depreciation?

Answer 1

the production cost would be $300,000 a year

machine will cost $150,000.

Also a working capital of $25,000 is required

Assume the production will last for four years

using three-year MACRS method.

annual depreciation rate of 33.33%, 44.45%, 14.81% and 7.41% for the first four years.

The machine has no resale value after four years

If the tax rate is 35%

cost of capital is 15%

Calculate the NPV for Option two if using MACRS for depreciation?

Cash flow statements

Years	0	1	2	3	4
Initial investment	-150000
Annual cost		-300000	-300000	-300000	-300000
+ Tax benefits		105000	105000	105000	105000
+depreciation tax shield (calculation is below)		17498	23336	7776	3890
Initial networking capital	-25000
Release of working capital					25000
Net cash flow	-175000	-177502	-171664	-187224	-166110
PV of $1 factor @ 15%rate	1	(1/1+15%)1 =0.869565	(1/1+15%)2 =0.756144	(1/1+15%)3 =0.657516	(1/1+15%)4 =0.571753
PV of Cash flow	-175000	-154349.52	-129802.70	-123102.78	-94974

Depreciation schedule (MACRS 3 year )

Years	Machine cost =	MSCRS rate	Depreciation exp	depreciation tax shield = Depreciation * tax rate
1	150000	33.33%	49995	17498
2	150000	44.45%	66675	23336
3	150000	14.81%	22215	7776
4	150000	7.41%	11115	3890.25

NPV = -175000 + -154349.52 + -129802.70 + -123102.78 + -94974

NPV =   - $677229