Question

Green House Tomato Company is considering the purchase of new processing equipment for $1,500,000, with an additional installation cost of $18,000. The new equipment will result in earnings before interest and taxes of $450,000 per year, and to operate the equipment properly, workers would have to go through an initial training session costing the company $50,000. In addition, because the equipment is extremely efficient, its purchase necessitates an increase in inventory of $90,000. Assume the company uses straight-line depreciation, the equipment has an expected life of seven years, the equipment will have no salvage value, the marginal tax rate is 28 percent, and the company has a required rate of return of 12 percent.

For each of the final values calculated below, you must show all component numbers that comprise the final value.

1. What is the initial outlay (year 0) associated with the equipment? (3 points)

2. What are the annual after-tax cash flows associated with the equipment for years one through six? (3 points)

3. What is the terminal cash flow in year seven? In other words, what is the annual after-tax cash flow in year seven? Do not forget any additional cash flows (inventory) associated with the termination of the equipment? (2 points)

Answer 1

Initial Outlay = cost of new equipment + installation cost + Inventory cost + training cost = 1500000+18000+90000+50000 = 1,658,000

Cash Flows = EBIT*(1-tax rate) + Depriciation

EBIT = 450000

tax rate = 28%

Depriciation charged according to SLM = Cost of Equipment/Expected Life Time = 1500000/7 = 214,285.7143

So from year 1 to year 6 Cash Flows = 450000*72% + 214285.7143 = 53825.7143

But in year 7 an additionalamount will be added as the extra amount of inventory that was maintained for the new equipment will get released so funds will flow back into the organization.

Cash Flow in year 7 = EBIT*(1-tax rate) + Depriciation + Release of Inventory = 53825.7143 + 90000 = 143,825.7143