Question

You are considering adding a new item to your company’s line of products. The machine required to manufacture the item costs $600,000. The shipping costs are $2,000 and the installation costs are $28,000. It falls into the three-year MACRS classification. The MACRS three-year depreciation rates are 33%, 45%, 15%, and 7%. The new item would immediately require an investment in NWC of $55,000. You plan to market the items for three years and then sell the machine for $90,000. You expect to sell 25,000 items per year at a price of $22. You expect variable manufacturing costs to be $20 per item and NO fixed costs will be incurred. If the tax rate is 40% and your weighted average cost of capital is 14% per year, what is the net present value of selling the new item? What should you do?

Answer 1

Time line		0	1	2	3
Cost of new machine		-630000
Initial working capital		-55000
=Initial Investment outlay		-685000
3 years MACR rate			33.00%	45.00%	15.00%	7.00%
Unit sales			25000	25000	25000
Profits	=no. of units sold * (sales price - variable cost)		50000	50000	50000
-Depreciation	=Cost of machine*MACR%		-207900	-283500	-94500	44100	=Salvage Value
=Pretax cash flows			-157900	-233500	-44500
-taxes	=(Pretax cash flows)*(1-tax)		-94740	-140100	-26700
+Depreciation			207900	283500	94500
=after tax operating cash flow			113160	143400	67800
reversal of working capital					55000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				-54000
+Tax shield on salvage book value	=Salvage value * tax rate				17640
=Terminal year after tax cash flows					18640
Total Cash flow for the period		-685000	113160	143400	86440
Discount factor=	(1+discount rate)^corresponding period	1	1.14	1.2996	1.481544
Discounted CF=	Cashflow/discount factor	-685000	99263.16	110341.6	58344.538
NPV=	Sum of discounted CF=	-417050.6607

Donot make the investment as NPV is negative