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The Effect of Working Capital Investment on NPV

JB enterprises purchased a new molding machine for $75,000. The company paid $6,000 for the shipping and another $4,000 to get the machine integrated with the existing assets.The company purchased a supply of oil for $2,000. The machine was to be depreciated on a straight line basis over its expected useful life of 10 years. JB is replacing an old machine that was purchased 7 years ago for $50,000. The old machine was being depreciated on a a straight line basis over a 10 year expected life. The machine was sold for $10,000. JB's marginal tax rate is 40%. What is the amount of the initial outlay?

A) $75,000

B) $77,000

C) $81,000

D) $85,000

Which of the following statements concerning the change in working capital is most accurate?

A). The $2,000 paid for oil is added to the initial outlay, offset by the tax savings of $800

B) The $2,000 may be expensed each year over the life of the project as part of the incremental free cash flows

C) The $2,000 is added to the initial outlay and recaptured during the terminal year, hence having no impact on the projects NPV or IRR

D) Even if the $2,000 is fully recovered at the end of the project, the projects NPV and IRR will be lower if the change in working capital is included in the analysis.

Solution Preview

1. In net present value analysis, we look at incremental cash flows (i.e., cash flows which would, or would not, occur if the decision were made). For purposes of net present value analysis, we consider any cash inflows to offset the cost of the investment; this net amount is the "initial outlay". In this case, the initial outlay is:

Cost of new machine $(75,000)
Shipping ( 6,000)
Adapting the machine ( 4,000)
Cost of oil ( 2,000) ...

Solution Summary

This solution discusses the effect of an investment in net working capital on the computation of a project's net present value.

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