Question

1. You have been asked by the president of Ellis Construction Company, headquartered in Toledo, to evaluate the proposed acquisition of a new earthmover. The mover’s basic price is $65,000, and it will cost another $14,000 to modify it for special use by Ellis Construction. Assume that the earthmover falls into the MACRS 3-year class. (See Table 10A.2 at the end of Chapter 10 for MACRS recovery allowance percentages.) It will be sold after three years for $26,000, and it will require an increase in net working capital (spare parts inventory) of $2,900. The earthmover purchase will have no effect on revenues, but it is expected to save Ellis $27,500 per year in before-tax operating costs, mainly labor. Ellis’s marginal tax rate is 35 percent. A) What is the company’s net initial investment outlay if it acquires the earthmover? (That is, what is the Year 0 net cash flow?) B). What are the incremental operating cash flows in Years 1, 2, and 3? C). What is the terminal cash flow in Year 3? D). If the project’s required rate of return is 10 percent, should the earthmover be purchased? Use NPV, IRR, and MIRR to answer this question. E). Calculate the traditional payback period and the discounted payback period for this project.

Answer 1

Year	0	1	2	3
basic price	-65000
cost of modification	-14000
Investment in Inventory	-2900
Annual operating savings		27500	27500	27500
less annual depreciation		26330.7	35115.5	11699.9
net operating savings		1169.3	-7615.5	15800.1
less tax -35%		409.255	-2665.425	5530.035
after tax savings		760.045	-4950.075	10270.065
add depreciation		26330.7	35115.5	11699.9
Incremental operating cash flow		27090.75	30165.425	21969.965
recovery of working capital				2900
after tax sale proceeds				19598.865
net operating cash flow	-81900	27090.75	30165.425	44468.83
present value of net operating annual cash flow = net operating cash flow/(1+r)^n r = 10%	-81900	24627.95	24930.10331	33410.09016
NPV = sum of present value of cash flow	1068.143464
IRR = Using IRR function in MS excel =irr(cell reference net operating cash flow year 0: cell reference net operating cash flow Year 3)	10.68%
MIRR = Using MIRR function in MS excel =Mirr(cell reference net operating cash flow year 0: cell reference net operating cash flow Year 3,finance rate,reinvestment rate) finance rate = 10% reinvesment rate =10%	10.48%
Net initial Investment outlay	-81900
Incremental operating cash flow
Incremental operating cash flow		27090.75	30165.425	21969.965
terminal cash flow in year 3 = recovery of investment in inventory+after taxsale proceeds	2900+19598.86	22498.86
selling price				27000
book value at the end of year 3 = cost of machine*(1-depreciation unrecovered)	79000*7.41%			5853.9
Gain on sale of equipment				21146.1
Tax on gain on sale of equipment	21146.1*35%			7401.135
after tax sale proceeds	27000-7401.13			19598.865
Year	net operating cash flow	cumulative cash flow
0	81900
1	27090.745	27090.75
2	30165.425	57256.17
3	44468.825	24643.83	amount to recovered
Payback period = year before final year of recovery+(amount to be recovered/cah flow of final year of recovery)	2+(24643.83/44468.82)	2.55
Year	present value of net operating annual cash flow = net operating cash flow/(1+r)^n r = 10%	cumulative present value of cash flow
0	81900
1	24627.95	24627.95
2	24930.10331	49558.05
3	33410.09016	32341.95
discounted Payback period = year before final year of recovery+(amount to be recovered/cah flow of final year of recovery)	2+(32341.95/33410.09)	2.968029
Year	1	2	3
cost of machine	79000	79000	79000
Macrs rate	33.33%	44.45%	14.81%
annual depreciation	26330.7	35115.5	11699.9
Yes earthmover should be purchased as NPV is positive and IRR and MIRR is more than the required rate of return of 10%