A manufacturer of electronic components in the 34% marginal tax bracket, is considering the purchase of a new fully automated machine to replace an older manually operated one. The machine being replaced now five years old, and originally had an expected life of 10 years, was being depreciated using the simplified straight line method from $20,000 down to zero, thus generating $2,000 in depreciation per year, and could be sold for $25,000. The replacement machine being considered had a purchase price of $50,000, a salvage value after five years of $10,000, and would be depreciated over five years using the simplified straight line depreciation method down to zero. In order to get the automated machine running, there would be a $3,000 shipping fee and a $2,000 installation charge. In addition, because the new machine would work faster than the old and investment in raw materials and goods-in-process inventories would need to be increased by a total of $5,000. The new machine will save the company $21,000 in operating expenses per year. The new machine requires maintenance workers to be specially trained; fortunately, a similar machine was purchased three months ago, and at that time the maintenance workers went through the $5,000 training program needed to familiarize themselves with the new equipment. The firms management is uncertain whether or not to charge half of this $5,000 training fee toward the new project. Finally, in order to purchase the new machine, it appears the firm would have to borrow additional $20,000 at 10 percent interest from its local bank, resulting in additional interest payments of $2,000 per year. The required rate of return on projects of this kind is 20 percent.
1. What is the project's initial outlay
2. What are the differential cash flows over the project's life
3. What is the terminal cash flow
4. Draw a cash flow diagram for this project
5. If the firm requires a minimum payback period on projects of this type for three years, should this project be accepted?
6. What is the net present value
7. Should the project be accepted? Why or why not?
The solution includes an excel file to show calculations of Depreciation, Free Cash Flows, NPV, and Payback Period.