Question

Massey Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $450,000 is estimated to result in $150,000 in annual pretax cost savings. The press falls in the MACRS five year class, and it will have a salvage value at the end of the project of $90,000. The press also requires an initial investment in spare parts inventory of $18,000, along with an additional $3,000 in inventory for each succeeding year of the project. If the shop’s tax rate is 35% and its discount rate is 14%, should Massey buy and install the machine press?

PLEASE EXPLAIN HOW TO SOLVE WITHOUT USING EXCEL. Thank you.

Answer 1

NOTE: Excel has been used only to feed in the values and to illustrate the explanation more clearly.

Due to this project, the company will have some cash outflows and some cash inflows.

So, the process of finding out whether the company should go ahead with the project is by finding out the total cash inflows over the horizon of 4 years (horizon of the project) and then discounting the cash flows at the given discount rate (14%) and then compare the resulting number with the discounted value of the cash outflows.

If the discounted cash inflows are more than the discounted cash outflows then it would mean that the net present value of the project is more than zero and the project should be accepted.

Step 1 - Identifying the cash outflows

As per the question, the cash outflows have been plotted over the horizon of the project.

Step 2 - Identifying the cash inflows

The inflows have been calculated considering the depreciation rate as per MACRS five year class and given tax rate.
After deriving the net profit, the depreciation has been added back as it is not a cash outflow in real but just a book entry.

Step 3 - In the end, the company also gets back the salvage value of the machinery and the working capital invested over the years which would be considered as an inflow. So, this would be added to the cash inflow.

Finally, we get all our cash flows for the project.

Step 4

The final step involves discounting these cash flows back to the beginning period with the given rate (14%).

As the NPV value stands negative, therefore, the project should not be undertaken.