Question

HT Tool Company HT Tool Co is considering the purchase of a new CNC milling machine to enhance the quality of its custom fabrication services. This project is not expected to change sales, but should save the firm in labor costs. The annual labor savings is expected to be $74,350 (before tax) but the machine will use more electrical power, which is expect to cost $2,400 each year. The machine costs $145,000. It will require $21,000 in modifications to support the needs of HT Tool. An increase in inventory (net working capital) of $5,150 will be necessary. • The machine will be depreciated using MACRS with a 3-year class life (half-year convention). The firm's tax rate is 35%. The plan is to sell the machine after 3 years and the expected selling price then is estimated at $65,000. The hurdle rate for this project is 10.5% Begin with a blank unused worksheet and show your setup: a. What is the initial investment of this project? (Year Onet cash flow). b. What are the net operating cash flows for years 1, 2, and 3? C. What is the terminal (NOT operating) cash flow in year 3? d. What are the NPV and IRR for this project? e. Should be accepted?

Answer 1

Answer (a):

Initial investment = Cost of machine + modification cost + increase in net working capital

= 145000 + 21000 + 5150

= $171,150

Initial investment = $171,150

Answer (b):

Year Operating cash flow $66,132.23 $72,592.95 $55,372.11

Working:

Year Saving in labor cost Additional power cost MACRS depreciation rate Depreciation EBIT Tax at 35% 1 $74,350.00 -$2,400.00 33.33% $55,327.80 $16,622.20 -$5,817.77 $10,804.43 $55,327.80 $66,132.23 2 $74,350.00 $2,400.00 44.45% $73,787.00 $1,837.00 $642.95 $1,194.05 $73,787.00 $72,592.95 $74,350.00 $2,400.00 14.81% - $24,584.60 $47,365.40 $16,577.89 $30,787.51 $24,584.60 $55,372.11 EAT Add back depreciation Operating cash flow

Answer (c):

Terminal cash flow = $51,705.21

Working:

$110,672.20 $36,885.20 Year Terminal cash flow Book value of machine Salvage value of machine Tax on gain Salvage value net of tax Recovery of NWC Terminal cash flow $12,300.60 $65,000.00 -$18,444.79 $46,555.21 $5,150.00 $51,705.21

Answer (d):

NPV = $27,512,28

IRR = 18.74%

Working:

0 -$145,000.00 $21,000.00 -$166,000.00 $5,150.00 Year Cost of machine Cost of modification Installed cost Increase in NWC Saving in labor cost Additional power cost MACRS depreciation rate Depreciation EBIT Tax at 35% EAT Add back depreciation Operating cash flow $74,350.00 -$2,400.00 33.33% -$55,327.80 $16,622.20 -$5,817.77 $10,804.43 $55,327.80 $66,132.23 $74,350.00 $2,400.00 44.45% -$73,787.00 $1,837.00 $642.95 $1,194.05 $73,787.00 $72,592.95 $74,350.00 $2,400.00 14.81% -$24,584.60 $47,365.40 $16,577.89 $30,787.51 $24,584.60 $55,372.11 $110,672.20 $36,885.20 Terminal cash flow Book value of machine Salvage value of machine Tax on gain Salvage value net of tax Recovery of NWC $12,300.60 $65,000.00 -$18,444.79 $46,555.21 $5,150.00 $66,132.23 $72,592.95 $107,077.32 Cash flow NPV= IRR = -$171,150.00 $27,512.28 18.74%

Above excel with 'show formula' is as follows:

23 -145000 -21000 =B2+B3 -5150 1 Year 2 Cost of machine 3 Cost of modification 4 Installed cost 5 Increase in NWC 6 Saving in labor cost 7 Additional power cost 8 MACRS depreciation rate 9 Depreciation 10 EBIT 11 Tax at 35% 12 EAT 12 EAT 13 Add back depreciation 14 Operating cash flow 74350 |-2400 0.3333 =$B$4*C8 =C6+C7+C9 =C10-35% =C10+C11 --C9 =C12+C13 74350 -2400 0.4445 =$B$4*D8 =D6+D7+D9 =D10-35% =D10+D11 =-D9 |=D12+D13 74350 -2400 0.1481 =$B$4*E8 =E6+E7+E9 =E10-35% =E10+E11 --E9 =E12+E13 --B4+C9 =C17+D9 16 Terminal cash flow 17 Book value of machine 18 Salvage value of machine 19 Tax on gain 20 Salvage value net of tax 21 Recovery of NWC 23 Cash flow 24 NPV= 25 IRR = =D17+E9 65000 =(E18-E17)*-35% =E18+E19 --B5 =C14 =114 =D14 =E14+E20+E21 =B4+B5 =NPV(10.5%,C23:E23)+B23 =IRR(B23:E23)

Answer e:

YES

The project should be accepted.

NPV is positive at $27,512,28.

IRR at 18.74% is greater than hurdle rate of 10.5%.