Question

You have been asked to evaluate the proposed acquisition of a new machine. The machine's price is $1,000,000 and our accountant requires that it be written off over its 5-year class using straight-line depreciation to a book value of $0 even though we intend to keep it for only 3 years. Purchase of the machine would require an increase in net working capital of $20,000 at t=0 only. The machine would increase the firms before-tax revenues by $100,000 per year as well. It is expected to be used for 3 years and then be sold for $800,000. The firm's marginal tax rate is 40 percent, and the project's cost of capital is 18 percent.

A. What is the net investment required at t=0?

B. What are the operating cash flows each year?

C. What is the total value of the ending (non-operating) cash flow in year 3?

D. what is the projects NPV?

Answer 1

Time line		0	1	2	3
Cost of new machine		-1000000
Initial working capital		-20000
=a. Initial Investment outlay		-1020000
						100.00%
Profits			100000	100000	100000
-Depreciation	Cost of equipment/no. of years		-200000	-200000	-200000	400000	=Salvage Value
=Pretax cash flows			-100000	-100000	-100000
-taxes	=(Pretax cash flows)*(1-tax)		-60000	-60000	-60000
+Depreciation			200000	200000	200000
=b. after tax operating cash flow			140000	140000	140000
reversal of working capital					20000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				480000
+Tax shield on salvage book value	=Salvage value * tax rate				160000
=c. Terminal year after tax cash flows					660000
Total Cash flow for the period		-1020000	140000	140000	800000
Discount factor=	(1+discount rate)^corresponding period	1	1.18	1.3924	1.643032
Discounted CF=	Cashflow/discount factor	-1020000	118644.0678	100545.82	486904.7
d. NPV=	Sum of discounted CF=	-313905.4139