Question

Cost-Cutting ProposalsStarset Machine Shop is considering a 4-year project to improve its production efficiency. Buying a new machine press for $670,000 is estimated to result in $245,000 in annual pretax cost savings. The press falls in the 5-year MACRS class, and it will have a salvage value at the end of the project of $55,000. The press also requires an initial investment in spare parts inventory of $20,000, along with an additional $2,500 in inventory for each succeeding year of the project. If the shop’s tax rate is 23 percent and the discount rate is 8 percent, should the company buy and install the machine press?

Answer 1

Time line		0	1	2	3	4
Cost of new machine		-670000
Initial working capital		-20000
=Initial Investment outlay		-690000
5 years MACR rate			20.00%	32.00%	19.20%	11.52%	17.28%
Savings			245000	245000	245000	245000
-Depreciation	=Cost of machine*MACR%		-1E+05	-214400	-128640	-77184	115776	=Salvage Value
-working capital to be maintained			-2500	-2500	-2500	-2500
=Pretax cash flows			108500	28100	113860	165316
-taxes	=(Pretax cash flows)*(1-tax)		83545	21637	87672.2	127293.32
+Depreciation			134000	214400	128640	77184
=after tax operating cash flow			217545	236037	216312.2	204477.32
reversal of working capital						30000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)					42350
+Tax shield on salvage book value	=Salvage value * tax rate					26628.48
=Terminal year after tax cash flows						98978.48
Total Cash flow for the period		-690000	217545	236037	216312.2	303455.8
Discount factor=	(1+discount rate)^corresponding period	1	1.08	1.1664	1.259712	1.360489
Discounted CF=	Cashflow/discount factor	-690000	201431	202363.7	171715.6	223049.07
NPV=	Sum of discounted CF=	108558.9092

Buy machine as NPV is positive