Question

Cobra Golf Co.is considering a proposal to replace an existing casting machine for producing a new line of low quality golf clubs. The machine is expected to have a four-year useful life and will be depreciated according to 3-year MACRS (.25, .38, .37). The machine will cost the company $100,000 plus freight and installation costs of $20,000. The machine will be fully depreciated and will have an ending market value of $30,000. Expanding the product line will increase inventories by $10,000, but costs will decrease by $50,000 per year. Assume a tax rate of 40 percent and a cost of capital of 10 percent. What are the annual cash flows? And calculate the NPV and IRR.

Answer 1

Answer.

1. Calculation of annual cash flow

= Decrease in cost per year - Increase in invetories cost per year

= $50000 - $10000

  Annual cash flow = $40,000

2. Calculation of NPV

Working note 1

Total cost of asset = Cost of purchae+Freight &Installation charges

= $100000+20000

Total cost of asset =$1,20,000

Woking note 2-

Calculation of tax shield on depreciation

Year	Cost of asset (a)	Depreciation rate as per MACRs (b)	Depreciation amount (c=a*b)	Tax shield @ 40% (d=c*40%)
1	$120000	25%	$30000	$12000
2	$120000	38%	$45600	$18240
3	$120000	37%	$44400	$17760

Calculation of NPV

Year	Particulars	Cash Flow (a)	Discountin Factor @ 10% (b)	Present Value (c= a*b)
0	Cost of asset	-$1,20,000	1.00	-$1,20,000
1-4	Cash flow (wn.1)	$40,000	3.17	$1,26,800
4	Salvage value ($30000(1-0.40) (Refer note 1 below)	$18000	0.683	$12,294
1	Tax shield on depreciation (wn.2)	$12000	0.909	$10,908
2	Tax shield on depreciation	$18240	0.826	$15,066.24
3	Tax shield on depreciation	$17760	0.751	$13,337.76
	NPV			$58,406

Note 1- It is assumed that salvage value of asset is subject to tax deduction.

3. Calculation of IRR

at IRR,

Total Cash inflow = Total cash outflow

Total cash outflow = $1,20,000

Total cash inflow = Net cash flow of 4 years + Salvage value

= ($40000*4)+$18000

Total cash inflow = $1,78,000

Avg. cash flow = $1,78,000/4 years

= $44,500

Present value annity factor(PVAF) for IRR = Initial invetsment /Avg. cash flow

PVAF = $1,20,000 / $44,500

     PVAF = $ 2.70 (approx.)

Hence,

PVAF 16% for 1-4 year = 2.80

PVAF 18% for 1-4 year = 2.69

Hence IRR is between 16%-18%

Calculation of IRR

Year	Particulars	Cash Flow (a)	Discountin Factor @16% (b)	Present Value (c=a*b)	Discounting Factor @ 18% (d)	Present Value ((e=a*d)
0	Cost of asset	-$1,20,000	1.00	-$1,20,000	1.00	-$1,20,000
1-4	Cash flow	$40,000	2.80	$,1,12,000	2.69	$1,07,600
4	Salvage Value	$18,000	0.552	$9,936	0.516	$,9288
	NPV			$1936		-$3112

IRR,

=Start Rate+[surplus /surplus-(-defeciet)]*(end rate-start rate)

=16+[$1936/ $1936-(-$3112)] *(18-16)

= 16+ [$1936/$5048]*2

= 16+0.38*2*100

IRR = 16.76%

Note - Depreciation in not considered while calculating IRR because it is non cash item