Purple Haze Machine Shop is considering a four-year project to improve its produ

Question

Purple Haze Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $410,000 is estimated to result in $160,000 in annual pretax cost savings. The press falls in the MACRS five-year class, and it will have a salvage value at the end of the project of $69,000. The press also requires an initial investment in spare parts inventory of $14,000, along with an additional $1,900 in inventory for each succeeding year of the project. The shop’s tax rate is 30 percent and its discount rate is 8 percent. Calculate the NPV of this project. Should the company buy and install the machine press?

Explanation / Answer

Given:-

Project life= 4 years Cost of new machine = 410,000 salvage value = 69,000 Life of machine = 5 yrs

Annual pre tax cost saving = 160,000 Initial investment in spare parts = 14,000

Additional cost for each year in spare parts = 1900 tax rate = 30% Discount rate = 8% (assuming that it is after tax discount rate)

Computation of NPV:-

Working Note:-

Depriciation of machine = 410,000 - 69000 / 5yrs

=68,200

*Tax saving from depreciation tax shield – depreciation is a tax deductible expense

Conclusion : Yes the company should buy and install the machine press because its NPV is positive.

Item Years Amount ($) (A) Tax@30% (B) After tax Cash flow (A-B) Dis Rate@8% Present value of Cash flow Machine Cost 0 (410,000) - (410,000) 1 (410,000) Annual Cost saving 1-4 160,000 48,000 112,000 3.312 370,944 Initial invst in spare parts 0 (14,000) - (14,000) 1 (14,000) Annual invst in spare parts 1-4 (1900) 570 (1330) 3.312 (4,405) Annual depriciation 1-4 68,200 20,460* 20,460* 3.312 67,764 Salvage value 4 69,000 20,700 48,300 0.735 35,501 NPV 45,804

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