Question

New project analysis​ ​ Garcia's Truckin' Inc. is considering the purchase of a new production machine for ​$300,000. The purchase of this machine will result in an increase in earnings before interest and taxes of ​$40,000 per year. To operate the machine​ properly, workers would have to go through a brief training session that would cost ​$7,000 after taxes. It would cost ​$4,000 to install the machine properly.​ Also, because this machine is extremely​ efficient, its purchase would necessitate an increase in inventory of​$10,000.This machine has an expected life of 10 ​years, after which it will have no salvage value.​ Finally, to purchase the new​ machine, it appears that the firm would have to borrow​ $100,000 at 12 percent interest from its local​ bank, resulting in additional interest payments of ​$12,000 per year. Assume simplified​ straight-line depreciation and that the machine is being depreciated down to​ zero, a 33 percent marginal tax​ rate, and a required rate of return of 15 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 the machine be​ purchased?

Answer 1

Year 0 Cash flow      
Cost of machine   -300000  
Training cost   -7000  
transport and Installation cost   -4000  
purchase of inventory   -10000  
___________________________      
Total Cash flow at year 0   -321000  
___________________________      
Initial cash outlay is   -321000  

      
      
Cash flow from Year 1 to 9      
Incremental EBIT   40000  
less tax @ 33%   -13200  
___________________________      
Profit after tax   26800  
Add: Depreciation   30400  
(300000+4000)/10      
___________________________      
Free cash flow   57200  
___________________________      
      
Cash flow Year 10      
      
Incremental EBIT   40000  
less tax @ 33%   -13200  
___________________________      
Profit after tax   26800  
Add: Depreciation   30400  
(300000+4000)/10      
Add: working capital recovery   10000  
___________________________      
Free cash flow   67200  
___________________________      
      
      
      
      
Year 0 cash flows present value is same as   -300000  
Discount rate =   15%  
Year 1 to 9 have single cash inflows. So Present Value of Annuity formula will be used.      
      
Present value of Cash inflows = Annual amount * (1-(1/(1+r)^n) / r      
57200*(1-(1/(1+15%)^9))/15%      
272934.6002      
      
Present value of year 10 value = year 10 value/(1+i)^n      
67200/(1+15%)^10      
16610.81225      
      
NPV is Sum of present value of all cash flows      
-321000+272934.60+16610.81      
-31454.58754      
NPV is   -$31,454.59  
So Machine should be purchased      
      
      
Note : Increase in EBIT of $40000. So Depreciation would have vbeen deducted. Now added back to Calculate free cash flow