Question

2) Moody Blues Inc. is considering an upgrade to the firm's manufacturing facilities. The firm will be investing in robotics for the first time in its history. The fully installed cost is expected to be $2,500,000 and fall into the IRS 5 year depreciation life category. The firm uses the straight line depreciation method for tax purposes. At the end of year 4 the firm will need to pay the manufacturer (the seller) $30,000 for a software upgrade. This cash cost is expected to be fully tax deductible in year 4. The firm expects the robotics to increase the manufacturing capacity of the plant allowing it to produce and sell 20,000 more units each year. This is expected to produce an increase of $600,000 in cash based taxable income. The firm believes that the useful life of the robots will be approximately 6 years. At the end of year 6 the firm expects to be able to sell the used robots for 20% of the original installed cost reduced by a $50,000 disassembly and removal fee. The firm is in the 40% tax bracket and will use a hurdle rate of 12% to evaluate this particular capital budgeting project.

Answer 1

In the below table we have calculated present value of incremental cash flows and Net present value

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Remarks
Increase in cash based taxable income due to installation of Robot	600,000	600,000	600,000	600,000	600,000	600,000	Data taken as per Question
Depreciation for each year on robot	-500000	-500000	-500000	-500000	-500000		Installed cost of 2500000 depreciated over 5 years
Amount paid for software upgrade at end of year 4				-30000
Expected sale proceeds from Robots						450000	20% of original installed costs reduced by 50000 for removal fee
Total increase in taxable income from use of robots	100,000	100,000	100,000	70,000	100,000	1,050,000
Less: Tax @40%	-40000	-40000	-40000	-28000	-40000	-420000
Net increase in profits	60,000	60,000	60,000	42,000	60,000	630,000
Incremental cashflows due to use of Robots Net increase in post tax profits plus depreciation- A	560,000	560,000	560,000	542,000	560,000	630,000
Present Value Factor @12%-B	0.89	0.80	0.71	0.64	0.57	0.51
Present value of Incremental cashflows-A*B	500,000	446,429	398,597	344,451	317,759	319,178
Particulars	Amount
Total value of incremental cashflows	2,326,413	sum of all bold numbers
Less: cost of Robot	(2,500,000)
Net present value	(173,587)

From the above NPV calculation the project will be rejected as NPV is negative and it will not generate 12% return