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Homework answers / question archive / 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

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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?

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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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