Please show work and do entire question. Do not do in Excel. You have been asked
ID: 2742590 • Letter: P
Question
Please show work and do entire question. Do not do in Excel.
You have been asked by the president of the Farr Construction Company to evaluate the proposed acquisition of a new earth mover. The mover’s basic price is $50,000, and it would cost another $10,000 to modify it for special use. Assume that the mover falls into the MACRS 3-year class (see Appendix 11A), that it would be sold after 3 years for $20,000, and that it would require an increase in net working capital (spare parts inventory) of $2,000 at the start of the project. This working capital will be recovered at Year 3. The earth mover would have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm’s marginal federal-plus-state tax rate is 40%.
a. What are the Year-0 cash flows?
b. What are the operating cash flows in Years 1, 2, and 3?
c. What are the additional (nonoperating) cash flows in Year 3?
d. If the project’s cost of capital is 10%, should the earth mover be purchased?
Explanation / Answer
a. Year zero cash flow:
Purchase price = 50,000
Modification cost = 10,000
Net increase in working capital at the start = 2,000
So total year 0 cash flow = 50,000 +10,000 +2,000 = 62,000
b. Operating cash flows for years 1,2 and 3 are as shown in the table below:
The MACRS depreciation rates for the three years are 33.33% , 44.45% and 14.81%. The movers baisc price of 50,000 is depreciation. We do not include modification cost in the depreciation
c. The Non oeprating cah flow in year 3 is the salvage value
The sale price = 20,000
Book value - 50,000* 0.0741 = 3705
Tax value = 20,000 - 3705 = 16,295
Taxes = 0.4* 16.295 = 6518
Hence salavge value = 20,000 - 6518 = 13,482
Return of working capital = 2,000
Total non-operating cash flow in year 3 = 13,482 + 2000 = 15,482
d. We calculate the NPV to be:
As the NPV is negative, the earth mover should not be purchased
Year 1 2 3 Cost savings 20000 20000 20000 Depreciation 16665 22225 7405 Profit before tax 3335 -2225 12595 Taxes 1334 -890 5038 Net Income 2001 -1335 7557 Add back depreciation 16665 22225 7405 Operating cash flow 18666 20890 14962