Question

Realistic Company is evaluating the proposed acquisition of a new production machine. The machine’s base price is $260,000, and installation costs would amount to $28,000. An additional $14,000 in net working capital would be required at installation. The machine has a 3-year life using straight line depreciation. The machine would save the firm $110,000 per year in operating costs. The firm is planning to keep the machine in place for 3 years. At the end of the third year, the firm plans to sell the machine for $100,000. The firm has a required rate of return on investment projects of 12and a marginal tax rate of 21%. What is the NPV of the project?

Answer 1

The Calculation of NPV of the project requires determining the project initial outflow, cash flows for 3 years and terminal cash flow.

Let us first find the initial year cash outflow: This will include the cost of acquiring the machine $260,000 + installation costs $28000 and Net working capital required $14000.

therefore total cash outflow at year 0 = $302000

Now, we will find the cash flows for 3 years:

The machine would save the firm $110,000 per year in operating costs. This will increase its net profit directly by $110,000 per year. for the increase in profit, the company has to pay a marginal tax rate of 21%. so, the net total increase in profit = $86900 [110000 *(1-21%)].

$86900 - consider this as CFAT(1)

Now let's find the depreciation effect on profit and cash flow.

Incremental depreciation will result in saving in taxes and inturn into an increase in profit.

To calculate SLM depreciation: Machine total fixed price will be considered i.e. base price and installation cost.

The machine’s base price is $260,000, and installation costs would amount to $28,000 = $288000.

SLM depreciation is the total fixed cost of machine divided by the number of the useful life of the machine=$288000/3 =$96000

Now, This increase in depreciation will help us save taxes as this depreciation reduces the net profit.

Given:

Tax rate=21%, Depreciation= $96000, Increase in saving of taxes will increase the cash flow.

Cash tax benefit= 96000*21% = $20160, consider this CFAT(2)

Now add CFAT(1) and CFAT(2) to get the total cash flow from year 1 to year 3 = $107060

The last step will be the calculation of Terminal cash flow:

It will be calculated as $100,000 (the firm plans to sell the machine for $100,000) + $14,000 (net working capital) - $21000 (taxes paid = $100,000*21%).

The terminal Cash flow is $93000.

Now to calculate NPV of the project, you can use either TVM calculator or excel.

Initial Cash flow outflow = -$302000

cash flow from year 1 to year 3 = $107060

terminal cash flow = $93000 (This will come in year 3 cash flow)

the required rate of return on investment projects of 12%.

therefore, NPV is $21335.61.