Question

Masters Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $385,000 is estimated to result in $145,000 in annual pretax cost savings. The press falls in the ve-year MACRS class, and it will have a salvage value of $45,000 at the end of the project. The press also requires an initial investment in spare parts inventory of $20,000, along with an additional $3,100 in inventory at the end of each succeeding project year. At the end of the project all working capital is recovered.
If the shop's tax rate is 22% and its discount rate is 9%, should the company buy and install the machine press?

Answer 1

Answer:

Since the NPV is positive, then the company should buy and install the machine press.

Explanation:

We have to calculate the NPV of the project using the discount cash flow model:

the initial investment = $385,000 (depreciable machinery) + $20,000 spare parts + $3,100 = $408,100

depreciation expense (five year MACRS class)

• $385,000 x 20% = $77,000
• $385,000 x 32% = $123,200
• $385,000 x 19.20% = $73,920
• $385,000 x 11.52% = $44,352
• $385,000 x 11.52% = $44,352
• $385,000 x 5.76% = $22,176

Cash flow year 1 = [($145,000 - $77,000) x (1 - 22%)] + $77,000 = $130,040

Cash flow year 2 = [($145,000 - $123,200) x (1 - 22%)] + $123,200 = $140,204

Cash flow year 3 = [($145,000 - $73,920) x (1 - 22%)] + $73,920 = $129,362

Cash flow year 4 = {[($145,000 - $44,352) x (1 - 22%)] + $44,352} + $3,100 (recovered working capital) + $45,000 (salvage value) + $4,736 (tax credit on impairment loss*) = $175,693

*since the carrying value at the end of year 4 is $66,528 and the salvage value is $45,000, an impairment loss will = $21,528. This will result in lower taxes by $21,528 x 22% = $4,736

the NPV of the project = -$408,100 + $130,040/1.09 + $140,204/1.09² + $129,362/1.09³ + $175,693/1.09⁴ = -$408,100 + $119,303 + $118,007 + $99,891 + $124,465 = $53,566

Since the NPV is positive, then the company should buy and install the machine press.