Question

(New project analysis) The Chung Chemical Corporation is considering the purchase of a chemical analysis machine. Although the machine being considered will result in an increase in earnings before interest and taxes of $36,000 per year, it has a purchase price of $200,000, and it would cost an additional $7,000 to properly install the machine. In addition, to properly operate the machine, inventory must be increased by $8,000. This machine has an expected life of 10 years, after which it will have no salvage value. Also, assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 13 percent. a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with the termination of the project)? d. Should this machine be purchased?

Answer 1

a]	Purchase price of the machine	$           200,000
	+Cost of installation	$                7,000
	=Total cost of the machine	$           207,000
	+Increase in inventory	$                8,000
	=Initial outlay	$           215,000
b]	Incremental EBIT	$              36,000
	-Depreciation [207000/10]	$              20,700
	=Incremental operating profits before tax	$              15,300
	-Tax at 34%	$                5,202
	-Incremental NOPAT	$              10,098
	+Depreciation	$              20,700
	=Annual after tax cash flows - Years 1 to 9 -	$              30,798
c]	Annual after tax cash flows as at [b]	$              30,798
	-Recovery of investment in inventory	$                8,000
	=After tax cash flow in Year 10	$              38,798
d]	PV of annual after cash flows - Years 1 to 9 = 30798*(1.13^10-1)/(0.13*1.13^10) =	$           167,117
	+PV of after tax cash flow of Year 10 = 38798/1.13^10 =	$              11,429
	=Total PV of cash inflows	$           178,547
	-Initial outlay	$           215,000
	=NPV	$           (36,453)
	As the NPV is negative, the machine should not be
	pruchased.