Thornley Machines is considering a 3-year project with an initial cost of $900,0

Question

Thornley Machines is considering a 3-year project with an initial cost of $900,000. The project will not directly produce any sales but will reduce operating costs by $445,000 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 $96,000. The tax rate is 34 percent. The project will require $24,000 in extra inventory for spare parts and accessories. Should this project be implemented if Thornley's requires a rate of return of 12 percent? Why or why not

Explanation / Answer

Assumptions: 1) It is assumed that Thornley Machines is profit making en tity & paying tax @ 34%. Hence reduction in cost would be resultant into increase in EBT. 2) Additional inventory for spare parts and accessories, of $24,000 has been consumed during the life of the project.

Conclusion: If Thornley's requires a rate of return of 12 percent, this project should be implemented, because the project has positive NPV of $ 71,491.91.   

Computation of Net Presnet Value Year end Particulars DF Cash Flow ($) DCF($) i ii iii iv v vi =(iv x v) a Initial Investment 1.0000 -900,000.00 b Spare pasrt & accessories -24,000.00 c Total Outlay ( a + b) -924,000.00 d Reduction in operating cost 445,000.00 e Depreciation -300,000.00 f Additions to Inflow after Dep. ( d -e ) 145,000.00 g Tax on net additions 34% of f -49,300.00 h After tax additons 95,700.00 i Add back of depreciation 300,000.00 j Total net cash inflow ( h+ i) 2.4018 395,700.00 950392.26 k Sale of equipment 1- tax 0.7118 63,360.00 45099.65 l Net Present Value ( j + k -c) 71,491.91

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