Question

Yosef Drug Store is considering the purchase of an automated pill machine that fills prescriptions. The machine costs $600,000 and will last five years before becoming obsolete. The system will be depreciated using a three-year MACRS schedule and will be sold for $50,000 at the end of five years. The machine will allow Hilltop to reduce staffing and save $275,000 annually. The machine requires higher levels of inventory. Therefore, the project will require an additional $15,000 in working capital at the beginning of the project and an additional $4,000 in each subsequent year (years 1-4). All NWC investments will be recovered in the last year. Yosef has a 20 percent tax rate and expects an 8 percent return from its projects.

Answer 1

Answer:

Initial Investment = $600,000
Useful Life = 5 years

Depreciation Year 1 = 33.33% * $600,000
Depreciation Year 1 = $199,980

Depreciation Year 2 = 44.45% * $600,000
Depreciation Year 2 = $266,700

Depreciation Year 3 = 14.81% * $600,000
Depreciation Year 3 = $88,860

Depreciation Year 4 = 7.41% * $600,000
Depreciation Year 4 = $44,460

Depreciation Year 5 = $0

After-tax Salvage Value = Salvage Value * (1 - Tax Rate)
After-tax Salvage Value = $50,000 * (1 - 0.20)
After-tax Salvage Value = $40,000

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$600,000 - $15,000
Net Cash Flows = -$615,000

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $275,000 * (1 - 0.20) + 0.20 * $199,980
Operating Cash Flow = $259,996

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $259,996 - $4,000
Net Cash Flows = $255,996

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $275,000 * (1 - 0.20) + 0.20 * $266,700
Operating Cash Flow = $273,340

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $273,340 - $4,000
Net Cash Flows = $269,340

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $275,000 * (1 - 0.20) + 0.20 * $88,860
Operating Cash Flow = $237,772

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $237,772 - $4,000
Net Cash Flows = $233,772

Year 4:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $275,000 * (1 - 0.20) + 0.20 * $44,460
Operating Cash Flow = $228,892

Net Cash Flows = Operating Cash Flow - Investment in NWC
Net Cash Flows = $228,892 - $4,000
Net Cash Flows = $224,892

Year 5:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $275,000 * (1 - 0.20) + 0.20 * $0
Operating Cash Flow = $220,000

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $220,000 + $31,000 + $40,000
Net Cash Flows = $291,000

Required Return = 8%

NPV = -$615,000 + $255,996/1.08 + $269,340/1.08^2 + $233,772/1.08^3 + $224,892/1.08^4 + $291,000/1.08^5
NPV = $401,877

Therefore, NPV of the project is $401,877