CSM Machine Shop is considering a four-year project to improve its production ef
ID: 2647633 • Letter: C
Question
CSM Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $500,000 is estimated to result in $199,000 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 $62,500. The press also requires an initial investment in spare parts inventory of $22,500, along with an additional $4,500 in inventory for each succeeding year of the project. The shop
CSM Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $500,000 is estimated to result in $199,000 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 $62,500. The press also requires an initial investment in spare parts inventory of $22,500, along with an additional $4,500 in inventory for each succeeding year of the project. The shop
Explanation / Answer
Step 1: Calculate Depreciation for Each Year with the Use of MACRS Rates:
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Step 2: Calculate Book Value and After-Tax Salvage Value:
With the use of above calculated values, we need to arrive at the book value and after-tax salvage value of the press.
Book Value = Cost - Depreciation Upto Year 4 = 500,000 - (100,000 - 160,000 - 96,000 - 57,600) = $86,400
After-Tax Salvage Value = Salvage Value + (Salvage Value - Book Value)*Tax Rate = 62,500 + (86,400 - 62,500)*30% = $69,670 (the asset will be sold at a value less than the book value, resulting in a loss which would further result in a tax refund as shown by the second part of the formula)
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Step 3: Calculate Annual Operating Cash Flows:
Annual operating cash flows will be calculated with the use of pre-tax annual cost savings and depreciation values. The formula will be:
Annual Operating Cash Flow = Annual Pre-Tax Savings*(1-Tax Rate) + Depreciation*Tax Rate
Year 1 = 199,000*(1-30%) + 100,000*30% = $169,300
Year 2 = 199,000*(1-30%) + 160,000*30% = $187,300
Year 3 = 199,000*(1-30%) + 96,000*30% = $168,100
Year 4 = 199,000*(1-30%) + 57,600*30% = $156,580
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Step 4: Calculate NPV:
We will have to make adjustments for working capital required initially and throughout the life the project. Initial working capital will be treated as a part of the cost of the press and yearly workin capital will reduce the value of operating cash flow. All the working capital will be recovered at the end of year 4. The after-tax salvage value will be treated as a part of operating cash flow for Year 4.
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NPV = -500,000 - 22,500 + (169,300 - 4,500)/(1+12%)^1 + (187,300 - 4,500)/(1+12%)^2 + (168,100 - 4,500)/(1+12%)^3 + (156,580 - 4,500 + 22,500 + 4,500*4 + 69,670)/(1+12%)^4 = $53,481.77
Year Cost of the Machine (A) Depreciation Rates (B) Annual Depreciation (A*B) 1 500,000 20.00% 100,000 2 500,000 32.00% 160,000 3 500,000 19.20% 96,000 4 500,000 11.52% 57,600