hornley Machines is considering a 3-year project with an initial cost of $1,110,
ID: 2718151 • Letter: H
Question
hornley Machines is considering a 3-year project with an initial cost of $1,110,000. The project will not directly produce any sales but will reduce operating costs by $680,000 a year. The equipment is depreciated straight-line to a zero book value over the life of the project. At the end of the project the equipment will be sold for an estimated $165,000. The tax rate is 34 percent. The project will require $31,000 in extra inventory for spare parts and accessories. Should this project be implemented if Thornley's requires a rate of return of 19 percent? Why or why not?
Explanation / Answer
PV of cash outflow
Initial cost = $1110000
Extra inventory = $31000
Total PV of cash outflow= $1141000
It is given that equipment is depreciated straight-line to zero book value therefore per year depreciation = 1110000/3 = $370000
If these project is implemented operating cost will reduce by $680000 but tax saving which was occurring because of these operating cost will not be possible therefore effective reduction in operating cost = $680000*66% = $448800
Also, there will be tax saving because of depreciation of $125800 ($370000*34%)
Therefore effective cash inflow from effective reduction in operating cost plus tax saving because of depreciation = $448800+125800 = $574600
At the end of the project equipment will have book value of $0 but it is estimated that it would be sold for $165000 therefore effective inflow on sale of equipment = (165000-Tax) = (165000-(165000*34%) = $108900
PV of cash inflow
Year 1 to 3 = $574600*Annualised discounting rate for 3 years at 19% = $574600 * 2.13991676747 = $1229596.17458
Year 3 = (108900+31000)*0.5934158 = $83018.87042
Total PV of cash inflow = $1312615.045
NPV = $171615.045
The project should be implemented since NPV is positive
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