# New project analysis and investment outlay

(11-1)

Investment Outlay

Talbot Industries is considering an expansion project. The necessary equipment could be purchased for $9 million, and the project would also require an initial $3 million investment in net operating working capital. The company's tax rate is 40%.

a. What is the initial investment outlay?

Equipment Purchase = $9 million

Investment in net working capital =$3 million

Initial investment outlay =$12 million

b. The company spent and expensed $50,000 on research related to the project last year. Would this change your answer? Explain.

No. The amount spent on research last year is a sunk cost.

c. The company plans to house the project in a building it owns but is not now using. The building could be sold for $1 million after taxes and real estate commissions. How would this affect your answer?

We need to include the opportunity cost of using the building in the initial investment outlay. Thus, initial investment outlay will increase by $1 million to $13 million.

(11-2)

Operating Cash Flow

Cairn Communications is trying to estimate the first-year operating cash flow

(at t = 1) for a proposed project. The financial stuff has collected the following information:

Projected sales $18 million

Operating cost (not including depreciation) $9 million

Depreciation $4 million

Interest expense $3 million

Tax @40%

The company faces 40% tax rate. What is the project's operating flow for the first year (t =1)?

(11-3)

Net Salvage Value

Allen Air Lines is now in the terminal year of a project. The equipment originally cost $20 millions, of which 80% has been depreciated. Carter can sell the used equipment today to another airline for $5 million, and its tax rate is 40%. What is the equipment's after-tax net salvage value?

Selling price of equipment = $5 million

Book value of Equipment = Original cost * (1-accumulated depreciation)

= $20 million *(1-80%)=$4 million

Gain on sale of equipment = Selling price - Book value

= $5 million - $4 million = $1 million

Tax on gain @40% =$0.4 million

Net salvage value = Selling price - Tax

=$5 million - $0.4 million = $4.6 million

(11-6)

New-Project Analysis

The Campbell Company is evaluating the proposed acquisition of a new milling machine. The machine's base price is $108,000, and it would cost another $12,500 to modify it for special use. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The machine would require an increase in net working capital (inventory) of $5,500. The milling machine would have no effect on revenues, but it is expected to save the firm $44,000 per year in before-tax operating cost, mainly labor. Campbell's marginal tax rate is

35%.

a. What is the net cost of the machine for capital budgeting purposes?

(That is, what is the year-0 net cash flow?)

Base price of machine = $108,000

Modification cost =$12,500

Increase in Net working capital =$5,500

Total initial investment outlay =$126,000

b. What are the net operating cash flows in Years 1,2, and 3?

Depreciable basis for the machine = base price + modification cost

=$108,000+$12500=$120,500

Deprecation in year 1 @33% = $120,500*33%=$39,765

Deprecation in year 1 @45% = $120,500*33%=$54,225

Deprecation in year 1 @15% = $120,500*33%=$18,075

Item year 1 Year 2 Year 3

Expected before tax Savings $44000 $44000 $44,000

Depreciation $39,765 $54,225 $18,075

Operating income before tax $4,235 ($10,225) $25,925

Tax (@35%) $1,482 ($3,579) $9,074

Operating income after tax $2,753 ($6,646) $16,851

Add back depreciation $39,765 $54,225 $18,075

Operating cash flow $42,518 $47,579 $34,926

c. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of working capital)?

Selling price of machine at the end of 3 years = $65,000

Book value of machine at the end 3 years = $120,500-$39,765-$54225-$18,075=$8435

Gain on sale of machine = Selling price - Book value

= $65,000 - $8,435 = $56,565

Tax on gain @35% =19,798

Net salvage value = Selling price - Tax=$65,000-$19,798=$45,202

Return of net working capital = $5,500

Additional year 3 cash flow = $45,202 + $5,500=$50,702

d. If the project's cost of capital is 12%, should the machine be purchased?

Year Cash Flow Discount Factor Discounted cash flow

0 ($126,000) 1.000 ($126,000)

1 $42,518 0.893 $37,963

2 $47,579 0.797 $37,930

3 $85,628 0.712 $60,948

Cost of capital 12% NPV $10,841

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#### Solution Summary

The solution contains step by step workings for computation of cash flows and NPV.