You have been asked by the president and CEO of your firm to evaluate the propos

Question

You have been asked by the president and CEO of your firm to evaluate the proposed acquisition of a new labeling machine for the firm’s pharmacy production lines. The machine’s price is $50,000, and it would cost another $10,000 for transportation and installation. The machine falls into the MACRS three-year depreciation class, and hence the tax depreciation allowances are 0.33, 0.45, and 0.15 in years 1, 2, and 3 respectively. The machine would be sold after three years because the production line is being closed at that time. The best estimate of the machine’s salvage value after three years of use is $20,000. The machine would have no effect on the firm’s sales or revenue, but it is expected to save the firm $20,000 per year in before tax operating costs. The firm’s tax rate is 40 percent and its cost of capital is 10 percent.

       a. What is the project’s net investment outlay at Year 0?

       b. What is the project’s operating cash flows in years 1, 2, and 3?

       c. What are the terminal cash flows at the end of Year 3?

      d. If the Project has average risk, is it expected to be profitable?

Explanation / Answer

a. What is the project’s net investment outlay at Year 0?

Investment = machine’s price + cost of transportation and installation.

=  $50,000 + $10,000 = $60,000 is the project's Investment.

b. What is the project’s operating cash flows in years 1, 2, and 3?

c. What are the terminal cash flows at the end of Year 3?

Formula for Terminal cash flow is,
Terminal Cash Flow = After-tax Proceeds from Disposal ± Change in Working Capital

in this given problem we don't have any working capital requirement, So we need to just calculate the After-tax Proceeds from Disposal,

here, After-tax Proceeds from Disposal = Pre-tax Proceeds from Disposal Tax on gain on Disposal

Tax on Disposal = (Proceeds Book Value) × Tax Rate

= ($20,000 - 4,200) * 40% = 15*800 * 0.4 = 6,320 is the tax on disposal

Book Value = $60,000 - depreciation = $60,000 - (19,800 + 27,000 + 9,000)

=$60,000 - 55,800 =4,200

Terminal Cash Flow =After-tax Proceeds from Disposal

=$20,000 - 6,320 = $13,680 is the termina cash flow

year savings = a depreciation = b earnings before tax,
c =a+b tax @ 40%, d=c*40% Net income, e = c-d operating cash flows, f=e+b 1 $20,000 60,000 * 0.33 = 19,800 200 80 120 19,920 2 $20,000 60,000 * 0.45 = 27,000 -7,000 - -7,000 20,000 3 $20,000 + salvage value = 20,000 + 20,000 = 40,000 60,000 * 0.15 = 9,000 31,000 12,400 18,600 27,600

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