Question

Starset Machine Shop is considering a 4-year project to improve its production efficiency. Buying a new machine press for $390,000 is estimated to result in $148,000 in annual pretax cost savings. The press qualifies for 100 percent bonus depreciation, and it will have a salvage value at the end of the project of $48,000. The press also requires an initial investment in spare parts inventory of $21,000, along with an additional $3,150 in inventory for each succeeding year of the project. The shop’s tax rate is 21 percent and its discount rate is 8 percent. Calculate the NPV of this project. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Calculating Initial investment in project

Cost of machine = $390000

Initial investment in inventory = $21000

Initial investment in project in year 0 = Cost of machine + Initial investment in inventory = 390000 + 21000 = 411000

Calculating depreciation

Since the machine qualifies for 100% bonus depreciation, therefore full cost of machine will charged as depreciation in year 1. depreciation in year 1 = 100% of cost of machine = 100% x 390000 = 390000

Also depreciation for year 2 = depreciation for year 3 = depreciation for year 4 = 0

Calculating after tax operating cash flows

Incremental revenue for year 1 to 4 from machine = 0 , As machine results annual pretax cost savings therefore incremental costs for year 1 to 4 from machine = -148000

After tax operating cash flow = EBIT(1-tax rate) + Depreciation = (Incremental revenues - incremental costs - depreciation)(1-tax rate) + depreciation

So After tax operation cash flow for year 1 = [ 0 - (-148000) - 390000][1-21%] + 390000 = [148000 - 390000][1-21%] + 390000 = -242000 x 79% + 390000 = -191180 + 390000 = 198820

Similarly after tax operating cash flows can be found out for year 2 to 4, we get the following table

Calculating After tax Operating Cash flow
Year	1	2	3	4
Incremental Revenue	0	0	0	0
Incremental costs	-148000	-148000	-148000	-148000
Depreciation	390000	0	0	0
EBIT	-242000	148000	148000	148000
EBIT(1-tax rate)	-191180	116920	116920	116920
Plus: Depreciation	390000	0	0	0
After tax operating Cash Flow	198820	116920	116920	116920

Since an additional investment of $3150 is made in inventory each succeeding year of the project, therefore

Investment in inventory in year 1 = Investment in inventory in year 2 = Investment in inventory in year 3 = $3150

Calculating terminal cash flow

Total investment in inventory over the life of project will be recovered in year 4,

Investment in inventory recovered in year 4 = 21000 + 3150 + 3150 +3150 = 30450

Book value of machine at end of 4 years = 0

Terminal cash flow in year 4 = Salvage value of machine at end of 4 years + Investment in inventory recovered in year 4 - tax on gain from sale of machine = Salvage value of machine at end of 4 years + Investment in inventory recovered in year 4 - tax rate (Salvage value of machine at end of 4 years - Book value of machine at end of 4 years) = 48000 + 30450 - 21%(48000 - 0) = 48000 + 30450 - 10080 = 68370

Calculating net cash flow

Calculating Net cash flow for year 1 to 4
Year	1	2	3	4
After tax operating Cash Flow (a)	198820	116920	116920	116920
Incremental Investment in Inventory (b)	3150	3150	3150
Terminal cash flow (c)				68370
Net Cash Flow = (a) - (b) + (c)	195670	113770	113770	185290

Calculating NPV

Net present value = - initial investment in project in year 0 + Sum of present values of Net cash flows for year 1 to 4 discounted at 8%

Net present value = -411000 + 195670 / (1 + 8%) + 113770 / ( 1 + 8%)² + 113770 / ( 1 + 8%)³ + 185290 / ( 1 + 8%)⁴

Net present value = -411000 + 181175.9259 + 97539.4375 + 90314.2940 + 136193.6814 = 94223.3388 = 94223.34 (rounded to two decimal places)

Hence net present value of project = 94223.34