ABC Tool Works is a small tool shop located in a farming community. ABC repairs
ID: 2814569 • Letter: A
Question
ABC Tool Works is a small tool shop located in a farming community. ABC repairs and fabricates parts for farm machinery. Currently, the owner of ABC is considering buying a new lathe to meet its increased demand. The new lathe will cost $100,000. The increase in revenue due to the new machine will be $120,000 a year. The associated expenses will be $80,000 (not including deprecation) a year. The marginal tax for ABC currently is 30%. The new lathe can be used for six years. However, it can be depreciated at the rates of 35%, 30%, and 20%, 15% in years 1, 2, 3, and 4, respectively, from the date of purchase. Six years from now it will be worth $10,000 in the used machinery market. If the cash flows are risk free and the risk free rate is 10% per year, will you recommend ABC go for the new lathe?
Explanation / Answer
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Cost
-100000
Revenue (a)
120000
120000
120000
120000
120000
120000
Expenses (b)
80000
80000
80000
80000
80000
80000
Depreciation (c )
35000
30000
20000
15000
EBIT (d) = (a-b-c)
5000
10000
20000
25000
40000
40000
Tax (e) = (d x 30%)
1500
3000
6000
7500
12000
12000
Net Income = (d – e)
3500
7000
14000
17500
28000
28000
Resale Value
10000
The risk free rates are 10%
Net Present Value
= -100000 + 3500/(1.10) + 7000/(1.10)2 + 14000/(1.10)3 + 17500/(1.10)4 + 28000/(1.10)5 + 28000/(1.10)6 + 10000/(1.10)6
= -100000 + 3181.82 + 5785.12 + 10518.41 + 11952.73 + 17385.79 + 15805.27 + 5644.74
= -100000 + 70273.88
= - 29726.12
It is not worth to go with the project
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Cost
-100000
Revenue (a)
120000
120000
120000
120000
120000
120000
Expenses (b)
80000
80000
80000
80000
80000
80000
Depreciation (c )
35000
30000
20000
15000
EBIT (d) = (a-b-c)
5000
10000
20000
25000
40000
40000
Tax (e) = (d x 30%)
1500
3000
6000
7500
12000
12000
Net Income = (d – e)
3500
7000
14000
17500
28000
28000
Resale Value
10000