Question

You have been asked by the president of your Company to evaluate the proposed acquisition of a new earth mover. The mover’s basic price is $50,000, and it would cost another $10,000 to modify it for special use. Assume that the mover falls into the MACRS 5-year class that it would be sold after 5 years for $20,000, and that it would require an increase in net working capital (spare parts inventory) of $2,000 at the start of the project. This working capital will be recovered at Year 5. The earth mover would have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The machine can be sold for $15,000 at the end of 5 years. The firm’s marginal federal-plus-state tax rate is 21%.

If the project’s cost of capital is 10%, should the earth mover be purchased or not and why?

Briefly discuss the importance of cash flow analysis to a company.

Please use excel to solve

Answer 1

To decide on the acquisition of a new earth mover, it's crucial to perform a cash flow analysis and calculate the NPV of the investment, considering savings, costs, taxes, and salvage value. If the NPV is positive, the acquisition is advised. The importance of cash flow analysis to a company lies in its ability to provide a comprehensive financial impact assessment for informed decision-making.

Step-by-step explanation:

To evaluate the proposed acquisition of a new earth mover, one should conduct a thorough cash flow analysis to determine the potential financial impact on the company. Since the earth mover would save the company $20,000 annually in operating costs and fall under the MACRS 5-year class for depreciation, one must calculate the net present value (NPV) of the investment using Excel to incorporate the cost of the machine, modification cost, tax effects, salvage value, and recovery of working capital.

By discounting these cash flows using the project's cost of capital, which is 10%, the decision to purchase can be made if the NPV is positive. After 5 years, the total savings, tax shield from depreciation, sale of the machine for $15,000, and recovery of the $2,000 net working capital that was initially invested, all need to be considered in the analysis. If the NPV is positive, the company should proceed with the purchase. Otherwise, it would not be financially beneficial to do so.

The importance of cash flow analysis for a company can't be overstated. It ensures that all financial benefits and costs are taken into account over the life of the project, allowing for an informed investment decision that supports the firm's financial objectives.