CSM Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $499,000 is estimated to result in $198,000 in annual pretax cost savings. The press falls in the MACRS five-year class (MACRS Table), and it will have a salvage value at the end of the project of $62,000. The press also requires an initial investment in spare parts inventory of $22,400, along with an additional $4,400 in inventory for each succeeding year of the project. The shop’s tax rate is 40 percent and its discount rate is 11 percent.
| Requirement 1: |
| Calculate the NPV. (Do not round intermediate calculations. |
First, we will calculate the depreciation each year, which will be:
D1= $499,000(0.2000) = $99,800
D2== $499,000(0.3200) = $159,680
D3= $499,000(0.1920) = $95,808
D4== $499,000(0.1152) = $57,485
The book value of the equipment at the end of the project is:
BV== $499,000 – ($99,800 + 159,680 + 95,808 + 57,485)
BV= = $86,227
The asset is sold at a loss to book value, so this creates a tax refund.
Aftertax salvage value = $62,000 + ($86,227 – 62,000)(0.40)
Aftertax salvage value = $71,691
Using the depreciation tax shield approach, the OCF for each year will be:
OCf1 = $198,000(1 – 0.40) + 0.40($99,800) = $158,720
OCf2 = $198,000(1 – 0.40) + 0.40($159,680) = $182,672
OCf3 = $198,000(1 – 0.40) + 0.40($95,808) = $157,123
OCf4 = $198,000(1 – 0.40) + 0.40($57,485) = $141,794
Now, we have all the necessary information to calculate the project NPV. We need to be careful with the NWC in this project. Notice the project requires $22,400 of NWC at the beginning, and $4,400 more in NWC each successive year. We will subtract the $22,400 from the initial cash flow, and subtract $4,400 each year from the OCF to account for this spending. In Year 4, we will add back the total spent on NWC, which is $35,600. The $4,400 spent on NWC capital during Year 4 is irrelevant. Why? Well, during this year the project required an additional $4,400, but we would get the money back immediately. So, the net cash flow for additional NWC would be zero. With all this, the equation for the NPV of the project is:
NPV = – $499,000 – 22,400 + ($158,720 – 4,400)/1.11 + ($182,672 – 4,400)/1.112 + ($157,123 – 4,400)/1.113+ ($141,794 + 35,600 + 71,691)/1.114
NPV = $38,066.34
