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The cost of the new machine is $127,000. Installation will cost $20,000. $4,000 in net working capital will be needed at
the time of installation. The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. Simplified straight line depreciation is used. Class life is 5 years, and the firm is planning to keep the project for 5 years. Salvage value at the end of year 5 will be $50,000. 14% cost of capital; 34% marginal tax rate.
...
For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 46,461 = Revenue Costs Depreciation EBT Taxes EAT Depreciation reversal Annual Cash Flow
Project NPV:
CF(0) = -151,000. CF(1 - 4) = 46,461. CF(5) = 46,461 + 37,000 = 83,461. Discount rate = 14%. NPV = 46,461(PVIFA 14%, 4) +
83,461/(1.14)5 151,000 $27,721. We would accept the project.
Project Information: Problem 1a Cost of equipment = $400,000. Shipping & installation will be $20,000. $25,000 in net working capital required at setup. 3-year project life, 5-year class life. Simplified straight line depreciation. Revenues will increase by $220,000 per year. Defects costs will fall by $10,000 per year. Operating costs will rise by $30,000 per year. Salvage value after year 3 is $200,000. Cost of capital = 12%, marginal tax rate = 34%.
Problem 1a
Initial Outlay: (400,000) + ( 20,000) (420,000) + ( 25,000) ($445,000) Cost of asset Shipping & installation Depreciable asset Investment in NWC Net Initial Outlay
For Years 1 - 3:
220,000 10,000 (30,000) (84,000) 116,000 (39,440) 76,560 84,000 160,560 =
Problem 1a
Increased revenue Decreased defects Increased operating costs Increased depreciation ($420,000/5) EBT Taxes (34%) EAT Depreciation reversal Annual Cash Flow
Problem 1a
Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow
Problem 1a
Problem 1a
Terminal Cash Flow: 200,000 (10,880) 25,000 214,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow
Problem 1a Solution NPV and IRR: CF(0) = -445,000 CF(1 ), (2), = 160,560 CF(3 ) = 160,560 + 214,120 = 374,680 Discount rate = 12% NPV = 160,560 (PVIFA 12%, 2) + 374,680/(1.12)3 445,000 NPV = $93,044. Accept the project!
Problem 1b
Project Information: For the same project, suppose we can only get $100,000 for the old equipment after year 3, due to rapidly changing technology. Calculate NPV for the project. Is it still acceptable?
Problem 1b
Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow
Problem 1b
Terminal Cash Flow:
Problem 1b
Terminal Cash Flow: 100,000 23,120 25,000 148,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow
Problem 1b Solution NPV and IRR: CF(0) = -445,000. CF(1), (2) = 160,560. CF(3) = 160,560 + 148,120 = 308,680. Discount rate = 12%. NPV = $46,067. Accept the project!
Replacement project
The main difference between replacement project
and the previous examples are the calculation of cash flow, depreciation and salvage value. What matter in replacement analysis is the incremental effects of new machine (new asset
depreciation old asset depreciation; new asset salvage valueold asset salvage value) on
old asset salvage value at the end of project life (use to calculate
Replacement Project:
Problem 3
Old Asset (5 years old): Cost of equipment = $1,125,000. 10-year class life (remaining 5 years economic life) Simplified straight line depreciation. Can be sold for $400,000 today. The salvage value after 5 years is $150,000 Cost of capital = 14%, marginal tax rate = 35%.
Replacement Project:
Problem 3
New Asset: Cost of equipment = $1,750,000. Shipping & installation will be $56,000. $68,000 investment in net working capital. 5-year project life, 5-year class life. Simplified straight line depreciation. Will increase sales by $285,000 per year. Operating expenses will fall by $100,000 per year. Salvage value after year 5 is $650,000. Cost of capital = 14%, marginal tax rate = 34%.
Initial Outlay:
(1,750,000) + ( 56,000) (1,806,000) + ( 68,000) + 456,875
Problem 3
Cost of new machine Shipping & installation Depreciable asset NWC investment After-tax proceeds (sold old machine) (1,417,125) Net Initial Outlay
Problem 3
For Years 1 - 5:
385,000 (248,700) 136,300 (47,705) 88,595 248,700 337,295 = Increased sales & cost savings Extra depreciation ( new machine EBT Taxes (35%) EAT Depreciation reversal Differential Cash Flow
Problem 3
Terminal Cash Flow: 500,000 Extra salvage value (SV
Problem 3 Solution
NPV CF(0) = -1,417,125. CF(1 - 4) = 337,295. CF(5) = 337,295 + 393,000 = 730,295. Discount rate = 14%. NPV = 337,295(PVIFA 14%, 4) + 730,295/(1.14)5 1,417,125 = (55,052.07) We would not accept the project!