A. (Organizing cash flows, NPV, IRR) A company is evaluating the purchase of Mac

Question

A. (Organizing cash flows, NPV, IRR) A company is evaluating the purchase of Machine A. The new machine would cost $120,000 and would be depreciated for tax purposes using the straight-line method over an estimated ten-year life to its expected salvage value of $20,000. The new machine would require an addition of $30,000 to working capital. In each year of Machine A’s life, the company would reduce its pre-tax costs by $40,000. The company has a 12% cost of capital and is in the 35% marginal tax bracket.

a. Identify the incremental cash flows from investing in Machine A.

b. Calculate the investment’s net present value (NPV).

c. Calculate the investment’s internal rate of return (IRR).

d. Should the company purchase Machine A? Why or why not?

B.

(Organizing cash flows) Judy Entrepreneur is considering the purchase of a machine for $100,000; the machine would be depreciated to a $20,000 salvage value over an eight-year period using the straightline method. During its life, the machine would improve Judy’s annual cash earnings by $25,000 per year. The firm expects to sell the machine for its $20,000 salvage value at the end of the eight years. The firm’s federal tax rate on income is 35%. Calculate the incremental cash flows from:

a. The purchase of the machine

b. The depreciation of the machine

c. The operation of the machine

d. The sale of the machine

C.

(Identifying nominal numbers) A company is considering an investment that would cost $25,000 and return a net after-tax cash flow of $8,000 per year in each of the next five years.

a. Assume these figures include inflation forecasts. What numbers should enter the capital budgeting analysis?

b. Now assume the above figures do not include inflation, forecast to be 6% per year. What numbers should enter the capital budgeting analysis?

c. Why must the cash flows used in capital budgeting contain the impact of inflation?

d. What would be the bias if the impact of inflation were left out

Explanation / Answer

Machine Costs 120000 Depreciation (120000-20000)/10 10000 Working capital required 30000 Reduction in cost 40000 Cost of capital 12% Tax Rate 35% Cash outflow Machine Costs 120000 Working Capital 30000 Total Cash outflow 150000 Annuity Factor @ 12% for 10 years (1-(1+r)^-n)/r (1-(1.12)^-10)/0.12 5.650223 Cash Inflow(Savings) Present Value of Tax saving on Depreciation 10000*5.650223*35% 19775.78 Present value of cost savings 40000*5.650223*(1-0.35) 146905.8 Present value of asset on Salvage Value on asset since the book value is zero now 20000*(1-0.35)*(1/1.12^10) 4185.649 Total Cash Inflows 170867.2 Net Present Value = Cash Inflows - Cash outflows 170867.20-150000 20867.2 The Net Present value of Machine A is $20867.20 IRR is the rate where the net present value calculated would be zero Assume the IRR is 15.2154%% Annuity Factor @ 15.2154%% for 10 years (1-(1+r)^-n)/r (1-(1.152154)^-10)/0.152154 4.977839 Cash Inflow(Savings) Present Value of Tax saving on Depreciation 10000*4.977839*35% 17422.44 Present value of cost savings 40000*4.977839*(1-0.35) 129423.8 Present value of asset on Salvage Value on asset since the book value is zero now 20000*(1-0.35)*(1/1.152154^10) 3153.826 Total Cash Inflows 150000.1 The IRR would be approx 15.2154% The company should purchase the machine A since the NPV is positive and the IRR of the project is more than the cost of capital of the company B Cash outflow from Purchase of Machine $100000 Cash flow due to depreciation Tax Savings on depreciation Depreciation=(100000-20000)/8 10000 Tax Savings on Depreciation(10000*0.35*8) 28000 Cash earnings from Machine 25000*8*(1-0.35) 130000 Sale of Machine 20000*(1-0.35) 13000 C a If Inflation is included Cash outflow $25000 Cash Inflow(8000*5) 40000 b Cash outflow Cash Inflow(8000*5*1.06) 42400 The cash flow used in capital budgeting must contain the impact of Inflation as otherwise the cashflow would reflect the true picture of the project as with every year with the same money one is able to purchase less of goods due to increase in inflation If inflation was not considered than the project selected based on nominal number might not be correct

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