You have been asked by the president of your firm to evaluate the proposed acqui
ID: 2727900 • Letter: Y
Question
You have been asked by the president of your firm to evaluate the proposed acquisition of new special-purpose equipment. The equipment's base price is $500,000, and another $50,000 for its installation costs. The equipment falls into the MACRS 3-year class, and it will be sold at the end of the project’s 2-year life for $250,000. Use of the equipment will require net working capital investment equivalent to 20% of the following year’s incremental revenues. The equipment will increase annual revenues by $100,000, and save the firm $200,000 in annual operating costs. The annual revenues and operating costs are expected to grow at an annual
rate of 10% during the 2nd-year of the project. This equipment will be placed in an unoccupied site, which can otherwise be sold for $100,000 today. This site will be sold for the same price at the termination of the project. The depreciation of this site that your firm owns can be ignored. The firm's tax rate is 30 percent and the discount rate for the project is 12%.
(a) Compute the initial outlay of the project.
Compute the operating cash flows (OCF) in Years 1 and 2.
Compute the non-operating cash flows (i.e., capital spending and change in NWC) at
the end of Year 2.
What is your recommendation on this project according to the conceptually most correct
capital budgeting method? Why? Be concise!
the end of Year 2.
Explanation / Answer
1
Calculation of initial outlay of the project:
Equipment's base price
$ 500,000.00
Add: Installation costs
$ 50,000.00
Initial outlay of the project =
$ 550,000.00
2
Calculation of operating cash flows (OCF) in Years 1 and 2:
Year 1
Year 2
Increase annual revenues
$ 100,000.00
110000
(100000*110%)
Saving in annual operating costs
$ 200,000.00
220000
(200000*110%)
Total Revenue
$ 300,000.00
$ 330,000.00
Less: Depreciation
$ (183,315.00)
$ (244,475.00)
(550000*33.33%)
(550000*44.45%)
Income before tax
$ 116,685.00
$ 85,525.00
Less: Tax =Income before tax * 30%
$ (35,005.50)
$ (25,657.50)
Income after tax
$ 81,679.50
$ 59,867.50
Add: Depreciation
$ 183,315.00
$ 244,475.00
Operating cash flows (OCF)
$ 264,994.50
$ 304,342.50
3
Calculation of non-operating cash flows:
Year 2
Net working capital investment
(Incremental sales * 20%) = 10000*20% =
2000
4
Calculation of NPV of the project:
Year 0
Year 1
Year 2
Initial outlay of the project =
$ (550,000.00)
Operating cash flows (OCF)
$ 264,994.50
$ 304,342.50
Net working capital investment
$ (2,000.00)
Net cash flows (CF)
$ (550,000.00)
$ 264,994.50
$ 302,342.50
PV of $ 1 (PVF) (12%)
1.00000
0.89286
0.79719
1/(1+12%)^0
1/(1+12%)^1
1/(1+12%)^2
PV = CF*PVF =
$ (550,000.00)
$ 236,602.23
$ 241,025.59
NPV= Sum of PVs
$ (72,372.18)
The NPV of the project is negative hence it should not be accepted.
1
Calculation of initial outlay of the project:
Equipment's base price
$ 500,000.00
Add: Installation costs
$ 50,000.00
Initial outlay of the project =
$ 550,000.00
2
Calculation of operating cash flows (OCF) in Years 1 and 2:
Year 1
Year 2
Increase annual revenues
$ 100,000.00
110000
(100000*110%)
Saving in annual operating costs
$ 200,000.00
220000
(200000*110%)
Total Revenue
$ 300,000.00
$ 330,000.00
Less: Depreciation
$ (183,315.00)
$ (244,475.00)
(550000*33.33%)
(550000*44.45%)
Income before tax
$ 116,685.00
$ 85,525.00
Less: Tax =Income before tax * 30%
$ (35,005.50)
$ (25,657.50)
Income after tax
$ 81,679.50
$ 59,867.50
Add: Depreciation
$ 183,315.00
$ 244,475.00
Operating cash flows (OCF)
$ 264,994.50
$ 304,342.50
3
Calculation of non-operating cash flows:
Year 2
Net working capital investment
(Incremental sales * 20%) = 10000*20% =
2000
4
Calculation of NPV of the project:
Year 0
Year 1
Year 2
Initial outlay of the project =
$ (550,000.00)
Operating cash flows (OCF)
$ 264,994.50
$ 304,342.50
Net working capital investment
$ (2,000.00)
Net cash flows (CF)
$ (550,000.00)
$ 264,994.50
$ 302,342.50
PV of $ 1 (PVF) (12%)
1.00000
0.89286
0.79719
1/(1+12%)^0
1/(1+12%)^1
1/(1+12%)^2
PV = CF*PVF =
$ (550,000.00)
$ 236,602.23
$ 241,025.59
NPV= Sum of PVs
$ (72,372.18)
The NPV of the project is negative hence it should not be accepted.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.