Question

Problem 9-21 Cost-Cutting Proposals [LO 2]

CSM Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $491,000 is estimated to result in $190,000 in annual pretax cost savings. The press falls in the MACRS five-year class (MACRS Table), and it will have a salvage value at the end of the project of $58,000. The press also requires an initial investment in spare parts inventory of $21,600, along with an additional $3,600 in inventory for each succeeding year of the project. The shop’s tax rate is 40 percent and its discount rate is 10 percent.

  

Calculate the NPV. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

Net present value              $

Answer 1

First, we will calculate the depreciation each year, which will be:

D1 = $491,000(.2000) = $98,200

D2 = $491,000(.3200) = $157,120

D3 = $491,000(.1920) = $94,272

D4 = $491,000(.1152) = $56,563

The book value of the equipment at the end of the project is:

BV4 = $491,000 – ($98,200 + 157,120 + 94,272 + 56,563) = $84,845

The asset is sold at a loss to book value, so this creates a tax refund.

After-tax salvage value = $58,000 + ($84,845 – $58,000)(.40)

= $58,000 + $10,738 = $68,738

Using the depreciation tax shield approach, the OCF for each year will be:

OCF1 = $190,000(1 – .40) + .40($98,200) = $114,000 + $39,280 = $153,280

OCF2= $190,000(1 – .40) + .40($157,120) = $114,000 + $62,848 = $176,848

OCF3= $190,000(1 – .40) + .40($94,272) = $114,000 + $37,709 = $151,709

OCF4= $190,000(1 – .40) + .40($56,563) = $114,000 + $22,625 = $136,625

Now, we have all the necessary information to calculate the project NPV. We need to be careful with the NWC in this project. Notice the project requires $21,600 of NWC at the beginning, and$3,600 more in NWC each successive year. We will subtract the $21,600 from the initial cash flow, and subtract $3,600 each year from the OCF to account for this spending. In Year 4, we will add back the total spent on NWC, which is $32,400. The $3,600 spent on NWC capital during Year 4 is irrelevant. Why? Well, during this year the project required an additional $3,600, but we would get the money back immediately.

NPV = PV of Cash Inflows - PV of Cash Outflows

= [($153,280 - $3,600) / 1.10] + [($176,848 - $3,600) / 1.10²] + [($151,709 - $3,600) / 1.10³] +

[($153,280 + $68,738 + $32,400) / 1.10⁴] - ($491,000 + $21,600)

= $136,072.73 + $143,180.17 + $111,276.48 + $173,770.92 - $512,600 = $51,700.29