MBA Corp is considering whether to expand widget production. This would require the purchase of a...

MBA Corp is considering whether to expand widget production. This would require the purchase of a new widget-producing machine at a cost of $5,400,000. The machine would produce 450,000 widgets per year during its useful life of three years, and would be depreciated for tax purposes at a rate of $1,800,000 per year. The machine would not have any salvage value. Expanding widget production would also require the use of a building that could otherwise be leased for $500,000 per year. Working capital required for the new machine would be 12% of the next year’s sales. Widget prices are $20 and are expected to remain stable. The materials and labor required to produce a widget cost $12, and these costs are also expected to remain stable. The corporate income tax rate is 30%. The discount rate is 6% per year. (a) Forecast the incremental cash flows resulting from the purchase of a widget machine on a year-by-year basis and draw them on a timeline. (b) Decide whether MBA Corp should go ahead with the purchase of the new machine.

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Expert Solution

The cash flows are detailed as below:

Year	0	1	2	3
No. of widgets		4,50,000	4,50,000	4,50,000
Sale value per widget		$ 20.00	$ 20.00	$ 20.00
Variable cost per widget		$ 12.00	$ 12.00	$ 12.00
Sales		$ 90,00,000.00	$ 90,00,000.00	$ 90,00,000.00
Variable costs		$ -54,00,000.00	$ -54,00,000.00	$ -54,00,000.00
Opportunity cost of building		$ -5,00,000.00	$ -5,00,000.00	$ -5,00,000.00
Depreciation		$ -18,00,000.00	$ -18,00,000.00	$ -18,00,000.00
EBIT		$ 13,00,000.00	$ 13,00,000.00	$ 13,00,000.00
Taxes @ 30%		$ -3,90,000.00	$ -3,90,000.00	$ -3,90,000.00
EBIAT		$ 9,10,000.00	$ 9,10,000.00	$ 9,10,000.00
Add back depreciation		$ 18,00,000.00	$ 18,00,000.00	$ 18,00,000.00
Gross cash flows		$ 27,10,000.00	$ 27,10,000.00	$ 27,10,000.00
Capital investment	$ -54,00,000.00			$ -
Net working capital	$ -10,80,000.00			$ 10,80,000.00
Net cash flows	$ -64,80,000.00	$ 27,10,000.00	$ 27,10,000.00	$ 37,90,000.00
NPV @ 6%	$ 16,70,651.21
IRR	18.63%

The company should go ahead with the purchase of the widget machine as the project cash flows are yielding a positive NPV and an internal rate of returb significantly higher than the discount rate.

jeff jeffy answered 2 years ago

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