Garcia\'s Truckin\', Inc. is considering the purchase of a new production machin

ID: 2720318 • Letter: G

Question

Garcia's Truckin', Inc. is considering the purchase of a new production machine for $160,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $20,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $5,500 after tax. In addition, it would cost $3,500 after tax to install this machine correctly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $28,000. This machine has an expected life of 10 years, after which it will have no salvage value. Finally, to purchase the new machine, it appears that the firm would have to borrow $50,000 at 8 percent interest from its local bank, resulting in additional interest payments of $4,000 per year. Assume simplified straight-line depreciation, that this machine is being depreciated down to zero, a 37 percent tax rate, and a required rate of return of 11 percent. What is the initial outlay associated with this project? What are the annual after-tax cash flows associated with this project for years 1 through 9? What is the terminal cash flow in year 10 (that is, the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project)? Should this machine be purchased?

Explanation / Answer

a)Initial Outlay associated with the project = Cost of new Machine + Installation Cost before tax + Training Cost of staff after tax + Incresae in working capital

= 160,000 + (3500/0.63) + 5,500 + 28,000

= 160,000 + 5,556 + 5,500 + 28,000

= $199,056

b)Annual Depreciation = (160,000+5,556)/10

= $16,556

Annual after tax cash flows for Year-1 to Year-9 = (20000-4000-16,556)*0.63 + 16,556

= $16,206

c)Terminal cash flow in year-1 0 = Annual after tax cash flows for Year-1 to Year-9 + Recovery of working capital

= 16,206 + 28,000

= $44,206

d)NPV from the project = [16,206*PVIFA(11%,10) + 44,206*PVIF(11%,10)] – 199,056

= [16,206*5.8892 + 44,206*0.3522] – 199,056

= 111,010 – 199,056

= -$88,047

No the machine should not be purchased since NPV is negative