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New project analysis) Raymobile Motors is considering the purchase of a new production machine for $550,000
New project analysis) Raymobile Motors is considering the purchase of a new production machine for $550,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $120,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $27,000 after taxes. It would cost $4,000 to install the machine properly. Also, because the machine is extremely efficient, its purchase would necessitate an increase in inventory of $26,000. This machine has an expected life of 10 years, after which it will have no salvage value. Assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 38 percent marginal tax rate, and a required rate of return of 11 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?
Expert Solution
a. INITIAL OUTLAY OF THE PROJECT:
Purchase price = $550,000
Training cost = $27,000
Installation cost = $4,000
Inventory cost =$26,000
Total initial outlay = $607,000
?b. Annual cash flows of the project for years 1 through 9:
Earnings before interest and tax = $120,000
Less: Depreciation (554,000/10) = $55,400
Earnings before tax = $64,600
Less: Tax @ 38% = $24,548
Earnings after tax = $40,052
Add: Depreciation = $55,400
Annual cash flows =$95,452
c. Terminal Cash flows of the project in year 10 = Annual cash flows + increased investment in inventory
= $95,452 + 26,000 = $121,452
d. To decide whether the machine is purchased,we have to find out its NPV as follows:
Annual cash Flow = $95,452
PV factor = 11% for 10 Years = 5.8892
Present value of cash flows = Annual cash flow *Annuity factor +26000 *(PVIF 11%,10 year)
=$96478 * 5.8892 +26000*0.352= $562135.92 +$9152
=$571287.92
NPV= -Intial cost + Present value of cash flows
=-$607000 +$571287.92 = -35712.08
NPV is negative so, Machine should not be purchased.
Note : I did not consider trainning as part of machine cost for depreciation.
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