The ABC Corporation is going to invest in a new piece of equipment which will co
ID: 2801512 • Letter: T
Question
The ABC Corporation is going to invest in a new piece of equipment which will cost $275,000 and falls into 5-year MACRS property. It costs $20,000 for delivery and installation. The company spends $10,000 for the Research and Development related to this project at the initial year, and need to pay $20,000 the rent for the factory which the equipment will be installed every year. Because the company has another project to do in the same factory, it will rent the factory regardless of the installation of the new equipment. It is expected to increase revenues in the first year of operations by $130,000. Revenues are expected to grow 10% each year for the life of the project, which is 4 years. A new project will affect the firm’s existing projects. If the company installs the new equipment, the revenue of its existing projects decreases by $20,000 every year. Operating costs (excluding depreciation) are expected to $50,000 at year 1 and are expected to grow 15% each year for the life of the project. Initial net working capital needs are $10,000 and will be $5,000 each year during the entire period of the project (from year 1 to year 4). NWC is recovered each year. The firm believes it can sell the equipment in year 4 for $12,000. The marginal tax rate is 34% and the firm’s cost of capital is 7%. Use the provided Excel template on Moodle and decide based on both NPV and IRR rules.
1. Operating Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Sales - Cost - Depreciation = EBT - Tax = NI OCF = NI + Depreciation Depreciation Worksheet Year 0 Year 1 Year 2 Year 3 Year 4 Cost of equipment (basis) x Depreciation Rate Depreciation Accumulated Dep (AD) Book Value = Basis - AD 2. Change in Net Working Capital Year 0 Year 1 Year 2 Year 3 Year 4 Annual need Annual recovery Last year recovery Change in NWC 3. Net Capital Spending Initial investment Estimate selling price - BV when selling Ordinary gain (loss) Tax on gain (tax reduction) Estimate selling price - Tax (tax reduction) After-tax salvage 4. Total Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 1. OCF 2. Change in NWC 3. CAPEX Total CF I NPV IRR Decision: Reason:Explanation / Answer
Decision - The project should not be accepted as the NPV is negative and also the IRR is less than the cost of capital of 7%
1) Operating cash flow 0 1 2 3 4 Sales $1,30,000 $1,43,000 $1,57,300 $1,73,030 Less: opprotunity costs $20,000 $20,000 $20,000 $20,000 Incremental revenue $1,10,000 $1,23,000 $1,37,300 $1,53,030 Cost $50,000 $57,500 $66,125 $76,044 Depreciation $59,000 $94,400 $56,640 $33,984 EBT $1,000 -$28,900 $14,535 $43,002 Tax $340 -$9,826 $4,942 $14,621 NI $660 -$19,074 $9,593 $28,381 OCF = NI+ Dep $59,660 $75,326 $66,233 $62,365 Depreciation worksheet Cost of equipment $2,95,000 Depreciation rate 20% 32% 19.20% 11.52% Depreciation $59,000 $94,400 $56,640 $33,984 Accumulated dep (AD) $59,000 $1,53,400 $2,10,040 $2,44,024 Book value = basis-AD $2,36,000 $1,41,600 $84,960 $50,976 2. Change in net working capital Annual need $10,000 $5,000 $5,000 $5,000 $5,000 Annual recovery $10,000 $5,000 $5,000 $5,000 Last year recovery $10,000 $5,000 $5,000 $5,000 Change in NWC $5,000 $0 $0 $0 3. Net capital sepnding Initial investment $3,05,000 Estimated selling price $12,000 BV when selling $50,976 Ordinary loss -$38,976 Tax on loss -$13,252 Estimated selling price $12,000 Tax reduction -$13,252 After tax salvage $25,252 4. Total cash flow 1. OCF $59,660 $75,326 $66,233 $62,365 2. Change in NWC $5,000 $0 $0 $0 3. CAPEX -$3,05,000 $25,252 Total CF -$3,05,000 $64,660 $75,326 $66,233 $87,617 Discount rate $1 $0.935 $0.873 $0.816 $0.763 Present value of cash flows -$3,05,000 $60,430 $65,793 $54,066 $66,843 NPV -$57,869 IRR -1%Related Questions
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