GD company is evaluating the proposed acquisition of a new milling machine. The
ID: 2667988 • Letter: G
Question
GD company is evaluating the proposed acquisition of a new milling machine. The machines base price is $108,000, and it would cost another $12,500 to modify it for special use. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The machine would require an increase in net working capital (inventory) of $5,500. THe milling machine would have no effect on revenues, but it is expected to save the firm $44,000 per year in before tax operating costs, mainly labor. Campbells marginal tax rate is 35%. Show worka) What is the net cost of the machine for capital budgeting purposes? (That is, what is the year 0 net cash flow?)
b) What are the net operating cash flows in years 1, 2, and 3?
c) What is the additional year 3 cash flow (ie: the after tax salvage and the return of working capital?)
d) if the projects cost of capital is 12%, should the machine be purchased?
Explanation / Answer
a). Net cost of the machine: Machine base price = $108,000 Modifying cost = 12,500 So net cost of the mechine = $120,500 Depreciation = (Cost of the machine - Salvage value) / Estimated useful life = (108,000 - 65,000) / 3 years = 43,000 / 3 years Depreciation = $14,333 per year Depreciation = (Cost of the machine - Salvage value) / Estimated useful life = (108,000 - 65,000) / 3 years = 43,000 / 3 years Depreciation = $14,333 per year b). Net operating cash flows: Cash inflows in 1st year: annual savings = $44,000 Annual costs = 5,500 Annual operating income = 38,500 Less: tax (35% of 38,500) = 13,475 Operating cash flow after tax = 25,025 Add: depreciation = 14,333 Net operating cash flow in 1st year = $39,358 Net operating cash flow in 2nd year = $39,358 Net operating cash flow in 3rd year: annual savings = $44,000 Annual costs = 5,500 Annual operating income = 38,500 Less: tax (35% of 38,500) = 13,475 Operating cash flow after tax = 25,025 Add: depreciation = 14,333 Add: salvage value = 65,000 Add: return of working capital = 16,500 Net operating cash flow (39,358 +65,000 + 16,500) = $120,858 c). Additional cash flow in year 3: salvage value = 65,000 return of working capital = 16,500 Additional cash flows in year 3 = $81,500d) Net present value: Annual Cash in flows = 39,358 Present value of cash flows (3 years, 12%) = 2.402 x 39,358 Present value of cash inflows = $94,537.916 Present value of salvage value (3rd year, 12%) = 0.712 x 65,000 Present value of salvage value = 46,280 Present value of working capital returns = 0.712 x 16,500 = 11,748 Present value of cash inflows = $152,565 Presdent value of Cash out flows (108,000 + 12,500 + 16,500) = $137,000 Net present value = Present value of cash inflows - Present value of cash out flows = $152,565 - $137,000 Net present value = $15,565 The machine should be puerchased. Operating cash flow after tax = 25,025 Add: depreciation = 14,333 Net operating cash flow in 1st year = $39,358 Net operating cash flow in 2nd year = $39,358 Net operating cash flow in 3rd year: annual savings = $44,000 Annual costs = 5,500 Annual operating income = 38,500 Less: tax (35% of 38,500) = 13,475 Operating cash flow after tax = 25,025 Add: depreciation = 14,333 Add: salvage value = 65,000 Add: return of working capital = 16,500 Net operating cash flow (39,358 +65,000 + 16,500) = $120,858 c). Additional cash flow in year 3: salvage value = 65,000 return of working capital = 16,500 Additional cash flows in year 3 = $81,500
d) Net present value: Annual Cash in flows = 39,358 Present value of cash flows (3 years, 12%) = 2.402 x 39,358 Present value of cash inflows = $94,537.916 Present value of salvage value (3rd year, 12%) = 0.712 x 65,000 Present value of salvage value = 46,280 Present value of working capital returns = 0.712 x 16,500 = 11,748 Present value of cash inflows = $152,565 Presdent value of Cash out flows (108,000 + 12,500 + 16,500) = $137,000 Net present value = Present value of cash inflows - Present value of cash out flows = $152,565 - $137,000 Net present value = $15,565 The machine should be puerchased. annual savings = $44,000 Annual costs = 5,500 Annual operating income = 38,500 Less: tax (35% of 38,500) = 13,475 Operating cash flow after tax = 25,025 Add: depreciation = 14,333 Operating cash flow after tax = 25,025 Add: depreciation = 14,333 Add: salvage value = 65,000 Add: return of working capital = 16,500 Net operating cash flow (39,358 +65,000 + 16,500) = $120,858 c). Additional cash flow in year 3: salvage value = 65,000 return of working capital = 16,500 Additional cash flows in year 3 = $81,500
d) Net present value: Annual Cash in flows = 39,358 Present value of cash flows (3 years, 12%) = 2.402 x 39,358 Present value of cash inflows = $94,537.916 Present value of salvage value (3rd year, 12%) = 0.712 x 65,000 Present value of salvage value = 46,280 Present value of working capital returns = 0.712 x 16,500 = 11,748 Present value of cash inflows = $152,565 Presdent value of Cash out flows (108,000 + 12,500 + 16,500) = $137,000 Net present value = Present value of cash inflows - Present value of cash out flows = $152,565 - $137,000 Net present value = $15,565 The machine should be puerchased. The machine should be puerchased.
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