Question

Blue line machine shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $485,000 is estimated to result in $179,000 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 $45,000. The press also requires an initial investment in spare parts inventory of $15,000, along with an additional $4,000 in inventory for each succeeding year of the project. If the shop's tax rate is 35 percent and the project's required return is 9 percent, should the company buy and install the machine press?

Answer 1

Initial Investment = $485,000
Useful Life = 4 years

Depreciation Year 1 = 20.00% * $485,000
Depreciation Year 1 = $97,000

Depreciation Year 2 = 32.00% * $485,000
Depreciation Year 2 = $155,200

Depreciation Year 3 = 19.20% * $485,000
Depreciation Year 3 = $93,120

Depreciation Year 4 = 11.52% * $485,000
Depreciation Year 4 = $55,872

Book Value at the end of Year 4 = $485,000 - $97,000 - $155,200 - $93,120 - $55,872
Book Value at the end of Year 4 = $83,808

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $45,000 - ($45,000 - $83,808) * 0.35
After-tax Salvage Value = $58,582.80

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$485,000 - $15,000
Net Cash Flows = -$500,000

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $179,000 * (1 - 0.35) + 0.35 * $97,000
Operating Cash Flow = $150,300

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $150,300 - $4,000
Net Cash Flows = $146,300

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $179,000 * (1 - 0.35) + 0.35 * $155,200
Operating Cash Flow = $170,670

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $170,670 - $4,000
Net Cash Flows = $166,670

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $179,000 * (1 - 0.35) + 0.35 * $93,120
Operating Cash Flow = $148,942

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $148,942 - $4,000
Net Cash Flows = $144,942

Year 4:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $179,000 * (1 - 0.35) + 0.35 * $55,872
Operating Cash Flow = $135,905.20

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $135,905.20 + ($15,000 + 3 * $4,000) + $58,582.80
Net Cash Flows = $221,488

Required Return = 9%

NPV = -$500,000 + $146,300/1.09 + $166,670/1.09^2 + $144,942/1.09^3 + $221,488/1.09^4
NPV = $43,332.49

NPV of the machine press is positive; therefore, the company should buy and install the machine press.