18.) Cash flows estimation and capital budgeting: You are the head of finance de

Question

18.) Cash flows estimation and capital budgeting:
You are the head of finance department in XYZ Company. You are considering adding a new machine to your production facility. The new machine’s base price is $11,000.00, and it would cost another $2,570.00 to install it. The machine falls into the MACRS 3-year class (the applicable MACRS depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%), and it would be sold after three years for $1,850.00. The machine would require an increase in net working capital (inventory) of $860.00. The new machine would not change revenues, but it is expected to save the firm $26,235.00 per year in before-tax operating costs, mainly labor. XYZ's marginal tax rate is 36.00%.

If the project's cost of capital is 13.25%, what is the NPV of the project?

Explanation / Answer

Cost of Equipment = Base Price of Equipment + Installation Cost
Cost of Equipment = $11,000 + $2,570
Cost of Equipment = $13,570

Depreciation Expense Year 1 = $13,570 * 33.33%
Depreciation Expense Year 1 = $4,522.88

Depreciation Expense Year 2 = $13,570 * 44.45%
Depreciation Expense Year 2 = $6,031.87

Depreciation Expense Year 3 = $13,570 * 14.81%
Depreciation Expense Year 3 = $2,009.72

Book Value of Equipment at the end of Year 3 = $13,570 - $4,522.88 - $6,031.87 - $2,009.72
Book Value of Equipment at the end of Year 3 = $1,005.53

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax
After-tax Salvage Value = $1,005.53 - ($1,005.53 - $1,850) * 0.36
After-tax Salvage Value = $1,309.54

Initial NWC required = $860.00

OCF Year 1 = Pretax Cost Saving * (1 - tax) + tax * Depreciation
OCF Year 1 = $26,235.00 * (1 - 0.36) + 0.36 * $4,522.88
OCF Year 1 = $18,418.64

OCF Year 2 = Pretax Cost Saving * (1 - tax) + tax * Depreciation
OCF Year 2 = $26,235.00 * (1 - 0.36) + 0.36 * $6,031.87
OCF Year 2 = $18,961.87

OCF Year 3 = Pretax Cost Saving * (1 - tax) + tax * Depreciation
OCF Year 3 = $26,235.00 * (1 - 0.36) + 0.36 * $2,009.72
OCF Year 3 = $17,513.90

NPV = -$13,570 - $860 + $18,418.64/1.1325 + $18,961.87/1.1325^2 + $17,513.90/1.1325^3 + $860/1.1325^3 + $1,309.54/1.1325^3
NPV = $30,169.60

So, NPV of this project is $30,169.60

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