Question

Larry Inc. is considering the acquisition of a new piece of equipment. The machine’s price is $600,000. In addition, installation and transportation costs would be $50,000 and would require $10,000 in spare parts thus increasing the firm’s networking capital by that amount. The system falls into the MACRS 3-year class (depreciation rates of 33%, 45%, 15%, and 7%). The current machine it would replace could be sold for $50,000 and currently has no book value. It is estimated that the new equipment would increase productivity and thus increase the firm's before-tax revenues by $115,000 per year and would also reduce its operating costs by $20,000 per year because of its greater speed and efficiency. The equipment is expected to be used for 5 years and then be sold for $45,000. The firm’s marginal tax rate is 26% and Henry’s WACC is 7%.

A. What is the initial outlay?

B. What is the net cash flow for year 1?

C. What is the change in depreciation for year 1?

D. What is the salvage value of the project?

E. What is the NPV?

F. What is the IRR?

Answer 1

Below are the calculations:

Particulars	Remark	0	1	2	3	4	5
Sales increase	Given		1,15,000.00	1,15,000.00	1,15,000.00	1,15,000.00	1,15,000.00
Cost reduction	Given		20,000.00	20,000.00	20,000.00	20,000.00	20,000.00
EBITDA	Sales increase+Cost reduction		1,35,000.00	1,35,000.00	1,35,000.00	1,35,000.00	1,35,000.00
Depreciation	180/3		2,14,500.00	2,92,500.00	97,500.00	45,500.00
EBT	EBITDA-Depreciation		-79,500.00	-1,57,500.00	37,500.00	89,500.00	1,35,000.00
Tax	26% x EBT		-20,670.00	-40,950.00	9,750.00	23,270.00	35,100.00
EAT	EBT-Tax		-58,830.00	-1,16,550.00	27,750.00	66,230.00	99,900.00
Depreciation	Added back as non cash		2,14,500.00	2,92,500.00	97,500.00	45,500.00	-
OCF	EAT+Depreciation		1,55,670.00	1,75,950.00	1,25,250.00	1,11,730.00	99,900.00
FCINV	Given	-6,13,000.00
WCINV	Given	-10,000.00					$    10,000.00
Salvage value	Given						$    45,000.00
Tax on profit from sale	26% x (Salvage value - BV)						$   -11,700.00
FCF	OCF+FCINV	-6,23,000.00	1,55,670.00	1,75,950.00	1,25,250.00	1,11,730.00	1,43,200.00
Discount factor Formula	at 7 %	1/(1+0.07)^0	1/(1+0.07)^1	1/(1+0.07)^2	1/(1+0.07)^3	1/(1+0.07)^4	1/(1+0.07)^5
Discount factor	Calculated using above formula	1.00	0.93	0.87	0.82	0.76	0.71
DCF	FCF x Discount Factor	-6,23,000.00	1,45,485.98	1,53,681.54	1,02,241.31	85,238.28	1,02,099.62
NPV = sum of all DCF	-34,253.26

• Initial outlay = Cost of new machine+installation cost-Salvage value of the old machine+Tax savings on sale
  • Initial outlay = 600000+50000-(50000-0.26 x 50000)
  • Initial outlay = 613000
  • As it is an outlay, it has to be negative
• Depreciation is calculated as per the MACRS schedule

  • Year	Opening balance	Depreciation rate	Depreciation	Closing balance
    1	$        6,50,000.00	33.00%	$ 2,14,500.00	$      4,35,500.00
    2	$        4,35,500.00	45.00%	$ 2,92,500.00	$      1,43,000.00
    3	$        1,43,000.00	15.00%	$     97,500.00	$         45,500.00
    4	$            45,500.00	7.00%	$     45,500.00	$                         -

  • Opening balance of year 1= Cost+installation
    • Opening balance of year 1= 600000+50000
    • Opening balance of year 1= 650000
  • Opening balance = previous year's closing balance for all years after year 1
  • Depreciation rates are original rates as per the MACRS schedule
  • Depreciation = depreciation rate x cost
  • Closing balance = Opening balance - depreciation
• NPV is negative so should not be invested in