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M Garage is evaluating buying new testing equipment which will increase profits by $18,000 per year
M Garage is evaluating buying new testing equipment which will increase profits by $18,000 per year. The project will require $45,000 in fixed assets investment, which will be depreciated straight-line to zero book value over the 3-year life of the project. It will cost $1000 to ship and install these assets and another $500 to train employees to operate the equipment. At the end of the third year, the salvage value of assets is estimated to be $1,600. Also, net working capital required is expected to increase by $3,000. The firm’s applicable tax rate is 40 percent.
a) What are the annual cash flows for years 1 and 2?
b) What is the cash flow for year 3?
c) Should the garage buy the equipment or not?
Expert Solution
Initial cost of machine (depreciable base) = Base cost + shipping cost + training cost = 45,000 + 1,000 + 500 = 46,500
| Year, n | Linkage | 0 | 1 | 2 | 3 |
| Initial cost | A | -46,500 | |||
| Investment in working capital | B | -3,000 | 3,000 | ||
| Post tax profit | C = 18000 x (1 - 40%) | 10,800 | 10,800 | 10,800 | |
| Depreciation tax shield | D = -A/3 x 40% | 6,200 | 6,200 | 6,200 | |
| Post tax salvage value | E = 1,600 x (1 - 40%) | 960 | |||
| Annual cash flows | Sum of all the items above | -49,500 | 17,000 | 17,000 | 20,960 |
a) What are the annual cash flows for years 1 and 2?
Year 1 = $ 17,000
Year 2 = $ 17,000
as shown in the last row of the table above
b) What is the cash flow for year 3?
$ 20,960 (Last cell in the last row)
c) Should the garage buy the equipment or not?
No one on the planet earth can answer this question unless you provide the hurdle rate or discount rate or desired rate of return. This question can be answered by NPV calculation but some kind of discount rate is required.
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