Question

1. Lee Corp. is evaluating the purchase of a machine that has a price tag of $250,000. It is estimated that shipping and installation costs for this machine will amount to $25,000. Further, the purchase of this machine will require an initial investment of $40,000 in net working capital (raw materials inventory etc.) which is expected to be reversed and recovered exactly when the machine is sold in the future. If it purchases the machine, Lee expects to employ it for a total of 6 years, and then sell it for an estimated $100,000.

During each of those 6 years, the machine is expected to contribute $95,000 to the sales revenue of the company, though it will also entail additional operating costs (NOT including depreciation) of $35,000 annually. If purchased, the machine will be fully depreciated over 6 years.

1. Find the initial (i.e. Time 0) cash outlay this machine will require.
2. Find the annual incremental operating cash flow (OCF) this machine will require for Times 1, 2, 3, 4, & 5.
3. Find the “terminal cash flow” (i.e. Time 6 cash flow) associated with this machine.
4. Find the internal rate of return (IRR) of this project.
5. Based on its IRR, should the project be taken? Explain.
6. Find the net present value (NPV) of this project.
7. Based on its NPV, should the project be taken? Explain.
8. For parts E and G above, what are you implicitly assuming about the risk of the project under consideration?

*Please solve using an explanation with an Excel file. Thank you!

Answer 1

a	Machine cost	250000
b	Shipping and installation	25000
c	Fxied cost	275000	(a+b)
d	Working capital	40000
e	Salvage value	100000
f	No of years to be used	6
g	Depreciation annual	45833	c/f
h	Sales revenue contribution	95000
i	additional operating costs	35000
A	T0 cash outlay	-315000	c+d
B	Annual incremental operating cash flow	60000
C	Terminal cash flow (Includes annual incremental operating cash flow for T6)	200000	e+d+B
D	IRR	0.08
	Outflow	-315000
	Inflow (B*6+C)	500000
	IRR	500000/(1+r)^t=315000
E	Should project be undertaken based on IRR	Yes
F	Net present value	185000	Sum of T0 to T6
	T0 cash outlay	-315000
	1	60000
	2	60000
	3	60000
	4	60000
	5	60000
	6	200000
G	Should project be undertaken based on IRR	Yes, as it is positive
H	There is no Cost of capital provided in the question. If the cost is less than IRR of 8%, the project can be accepted. Also NPV is calculated without discount rates as the rates are not provided. As there is no tax rates provided, tax on income and depreciation tax benefit is ignored as well.