Answer:
a. Year 0 Net Cash Flows = $984,000
b. We have:
Year 1 net operating cash flows = $306,159
Year 2 net operating cash flows = $332,986
Year 3 net operating cash flows = $261,479
c. Additional Year 3- cash flow = $504,877
d. The machine should be purchased.
Explanation:
We start by first calculating the following:
Initial Investment = Base Price + Modification Cost = $940,000 + $25,000 = $965,000
Useful Life = 3 years
Depreciation in Year 1 = 0.3333 * $965,000 = $321,634.50
Depreciation in Year 2 = 0.4445 * $965,000 = $428,942.50
Depreciation in Year 3 = 0.1481 * $965,000 = $142,916.50
Book Value at the end of Year 3 = $965,000 - $321,634.50 - $428,942.50 - $142,916.50 = $71,506.50
After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * Marginal tax rate = $624,000 – ($624,000 - $71,506.50) * 25% = $485,877
Initial Investment in NWC = $19,000
We can now proceed as follows:
a. What is the Year 0 net cash flow?
Year 0 Net Cash Flows = Initial Investment + Initial Investment in NWC = $965,000 + $19,000 = $984,000
b. What are the net operating cash flows in Years 1, 2, 3?
Year 1 net operating cash flows = (Pretax Cost Saving * (1 - tax)) + (tax * Depreciation in year 1) = ($301,000 * (1 – 0.25)) + (0.25 * $321,634.50) = $306,159
Year 2 net operating cash flows = (Pretax Cost Saving * (1 - tax)) + (tax * Depreciation in year 2) = ($301,000 * (1 – 0.25)) + (0.25 * $428,942.50) = $332,986
Year 3 net operating cash flows = (Pretax Cost Saving * (1 - tax)) + (tax * Depreciation in year 3) = ($301,000 * (1 – 0.25)) + (0.25 * $142,916.50) = $261,479
c. What is the additional Year 3- cash flow (i.e. after tax salvage and the return of working capital)?
Additional Year 3- cash flow = NWC recovered + After-tax Salvage Value = $19,000 + $485,877 = $504,877
d. If the project's cost of capital is 12%, should the machine be purchased?
This can be determined from the net present value (NPV) calculated as follows:
NPV = -$984,000 + ($306,159/1.12^1) + ($332,986/1.12^2) + ($261,479/1.12^3) + ($504,877/1.12^3) = $100,287.71
Since the NPV of the machine of $100,287.71 is positive, the machine should be purchased.
