You are analyzing the purchase of new equipment. Since you are not an expert on

Question

You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $1,500 and recommended the purchase of the latest model from Equipment Corp. of America. The equipment costs $80,000, and it will cost another $10,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $28,000. Use of the equipment will require an increase in your companys net working capital of $4,000, but this $4,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $50,000 per year in before-tax operating costs. Your company's marginal tax rate is 35%. What is the incremental fee cash flow for the first year of the project? What is the terminal cash flow for this project? What is the initial outlay required to fund this project?

Explanation / Answer

Incremental Cash Flow: Cash Inflows Cash Outflows (Inflows Outflows Depreciation) × Tax Rate

Depreciation Expense = $90,000/6 = $15,000

Tax for First Year = ($50,000 - $4,000 - $15,000) * 35% = $10,850

Incremental Cash Flow = $50,000 - $90,000 - $1,500 - $10,850 = -$52,350
So, total Incremental Cash Flow for first year is “Cash Outflow of $52,350.

Terminal Cash Flow = Recovery of Net Working Capital + Amount received by selling the machinery

                                    = $4,000 + $28,000 = $32,000

Initial Outlay Required = Cost of Equipment + Modification Cost + Increase in Net Working Capital

                                    = $80,000 + $10,000 + $4,000 = $94,000

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