Question

Tele Corp. is considering the purchase of a new production machine. The equipment's basic price is $250,000, installation costs are approximately $7,000, and the shipping fees are about $3,000. The equipment falls into MACRS 5-year class. However, the company plans to use the machine only for 3 years, at which time it can be sold for an estimated price of $111,580. (MACRS 5-year: 20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%.) This efficient new machine will produce additional sales of $70,300 per year for 3 years, and it will also result in a before-tax net reduction of costs and expenses by $15,860 per year. Use of the equipment will also require the following: an increase in spare part inventory of $9,000; an increase in prepaid expenses of $5,000; an increase in accounts payable of $2,000. The firm's marginal tax rate is 40%.

a. What is the Year- 0 net cash flow?
b. What are the cash flows in Years 1 and 2?
c. What is the cash flow in Year 3?
d. If the project’s cost of capital is 15.70%, should the new production machine be purchased based on NPV and IRR? Why or why not?

Answer 1

a. The Year-0 net cash flow is calculated by subtracting the initial outlay from the present value of the expected cash inflows. b. The cash flows in Years 1 and 2 are the additional sales minus cost savings. c. The cash flow in Year 3 is the additional sales minus cost savings plus the estimated selling price of the machine. d. To determine whether the new production machine should be purchased based on NPV and IRR, calculate the Net Present Value (NPV) and Internal Rate of Return (IRR) using the cost of capital.

Step-by-step explanation:

a. The Year-0 net cash flow is calculated by subtracting the initial outlay from the present value of the expected cash inflows. The initial outlay includes the basic price, installation costs, and shipping fees. The present value of the expected cash inflows is calculated by discounting the additional sales and cost savings using the cost of capital. Therefore, the Year-0 net cash flow can be calculated as follows:

Initial Outlay:

Basic Price + Installation Costs + Shipping Fees = $250,000 + $7,000 + $3,000 = $260,000

Present Value of Expected Cash Inflows:

(Additional Sales - Cost Savings) / (1 + Cost of Capital) ^ Year

Year 1: ($70,300 - $15,860) / (1 + 0.157) ^ 1 = $49,164.22

Year 2: ($70,300 - $15,860) / (1 + 0.157) ^ 2 = $43,355.64

Year 3: ($70,300 - $15,860) / (1 + 0.157) ^ 3 = $38,228.61

Year-0 Net Cash Flow:

Year-0 Net Cash Flow = Initial Outlay - Present Value of Expected Cash Inflows

Year-0 Net Cash Flow = $260,000 - ($49,164.22 + $43,355.64 + $38,228.61) = -$29,748.47

b. The cash flows in Years 1 and 2 are the additional sales minus cost savings. Therefore, the cash flows in Years 1 and 2 can be calculated as follows:

Year 1: $70,300 - $15,860 = $54,440

Year 2: $70,300 - $15,860 = $54,440

c. The cash flow in Year 3 is the additional sales minus cost savings plus the estimated selling price of the machine. Therefore, the cash flow in Year 3 can be calculated as follows:

Year 3: ($70,300 - $15,860) + $111,580 = $166,020

d. To determine whether the new production machine should be purchased based on NPV and IRR, we need to calculate the Net Present Value (NPV) and Internal Rate of Return (IRR) using the cost of capital. If the NPV is positive and the IRR is greater than the cost of capital, the project is considered favorable. If the NPV is negative or the IRR is less than the cost of capital, the project is considered unfavorable. It is important to note that NPV takes into account the time value of money by discounting the cash flows, while IRR measures the profitability of the investment. Therefore, the decision to purchase the new production machine should be based on the NPV and IRR calculations.