Mars, Inc. is considering the purchase of a new machine which will reduce manufa

Question

Mars, Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually. The company will depreciate the cost of the new machine using the straight line method over the project life and it expects to sell the machine at the end of its 5-year life for $10,000. The firm expects to be able to reduce net working capital by $15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 5 years. Mars' marginal tax rate is 40%, and it uses a 12% required rate of return to evaluate projects of this nature. If the machine costs $60,000, what are the NPV and IRR of the project? Please show work to be rated.

Explanation / Answer

Initial Investment = Machine cost - Working capital reduced

Initial Investment = 60000 - 15000 = 45000

Annual Depreciation = (60000-10000)/5 = 10000

Salvage value = 10000

Terminal Value = Salvage value - Working Capital return to orginal level

Terminal Value = 10000 - 15000

Terminal Value = - 5000

Annual Cash Flow = 5000*(1-40%) + 10000*40%

Annual Cash Flow = 7000

NPV = - 45000 + 7000/(1+12%) + 7000/(1+12%)^2+ 7000/(1+12%)^3 + 7000/(1+12%)^4 + 7000/(1+12%)^5 - 5000/(1+12%)^5

NPV = - 22603.70

At IRR NPV = 0

NPV = - 45000 + 7000/(1+r) + 7000/(1+r)^2+ 7000/(1+r)^3 + 7000/(1+r)^4 + 7000/(1+r)^5 - 5000/(1+r)^5

0 = - 45000 + 7000/(1+r) + 7000/(1+r)^2+ 7000/(1+r)^3 + 7000/(1+r)^4 + 7000/(1+r)^5 - 5000/(1+r)^5

45000 = 7000/(1+r) + 7000/(1+r)^2+ 7000/(1+r)^3 + 7000/(1+r)^4 + 7000/(1+r)^5 - 5000/(1+r)^5

By Solving above equation we get

IRR = - 13.57%

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