The Madison Prefabricated Buil

The Madison Prefabricated Buildings Co. is consideringadding a new line to its product mix. Marcy Mulholland is toconduct a capital budgeting analysis on the project. The productionline would be set up in unused space in Madison’s main plant. Thespace could be leased out at $25,000 per year. The machinery’sinvoice price is approximately $200,000; $10,000 in shippingcharges would be required; and it would cost $30,000 to install themachinery. The firm’s inventories would have to be increased by$25,000 to handle the new line, but its accounts payable would riseby $5,000. The machinery has an economic life of 4 years, andqualifies as a MACRS 3-year asset. The machinery is expected tohave a salvage value of $25,000 after 4 years. The new line wouldgenerate $125,000 in additional revenues in each of the next 4years. The firm’s marginal tax rate is 40% and its required returnis 10 percent.

a. Construct the cash flows for each year by modifyingan income statement. Be able to describe why you treated each cashflow as you did.

b. If the new product line decreases sales of the firm’sother lines by $50,000 per year, should this information beincluded in the analysis? If so, how would Ms. Mulholland doit?

c. Determine whether the machine should be purchased.Explain your decision.

d. How much taxes did you save by having depreciationexpense?


a Calculation of cash flows:
Year0 Year1 Year2 Year3 Year4 Comments
Opportunity cost of leasedspace 0 0 0 0 0 It will be not be included in cashflows as it is just an opportunity cost. It will be consideredwhile capital budgeting analysis
Machine cost -240000 Cost incurred on purchase ofmachinery,shipping cost and installation cost will be considered ascash flows
Increase in inventory -25000 Increase in inventory will be treatedas increase in working capital outflow as cash will be blockedthere
Increase in accountspayable 55000 Increase in accounts payable willdelay the cash outflow hence decreasing the working capitaloutflow.
Tax savings on depreciation (Refer WN-1) 28380 25929 4754 1886 Tax savings on depreciation willincrease the cash flow due to reduction in tax
Salvage cost net oftax(25000*0.60) 15000 Salvage value is a cash inflow foryear 4.
Additional revenue net oftax(125000*0.60) 75000 75000 75000 75000 Additional revenues generated as aresult of new project will be taken as cash inflow
Total Cash flows after tax for eachyear -210000 103380 100929 79754 91886
b. Decrease in sales of other lines by50000 will be deducted from cash flows of year that too net oftaxes(50000*0.60) -30000 -30000 -30000 -30000
As a result of part B, cash flows foreach year -210000 73380 70929 49754 61886
c. Whether machine should be purchased ornot, it will include the opportunity cost of space that could begiven on lease25000*0.60 15000 15000 15000 15000
Total outflows/inflows -210000 88380 85929 64754 76886
Required rate of return @10%PVF 1 0.909 0.826 0.751 0.683
Present value -210000 80337.42 70977.35 48630.25 52513.1
Net Present value 42458.17
As we can see net inflows arepositive, which means machine should be purchased as it will begenerating inflows, thereby increasing the profits and covering upthe initial cost machinery
d Year Opening Balance Rates for MACRS 3 years Depreciation Closing balance Tax savings on[email protected]%
Year1 215000 0.33 70950 144050 28380
Year2 144050 0.45 64822.5 79227.5 25929
Year3 79227.5 0.15 11884.13 67343.38 4753.65
Year4 67343.38 0.07 4714.036 62629.34 1885.61
Total tax savings due to depreciationexpense 60948.3
Tax provided on salvage value25000*0.40 10000
The rates for MACRS are the standardrates. This fixed rates will be used whenever MACRS 3 years isgiven in question. You may refer MACRS rate table.
WN-1 Cost of asset=200000+10000+30000= 240000
Less : salvage value -25000 215000
Year OpeningBalance Rates for MACRS 3years Depreciation Closingbalance Tax savings on[email protected]%
Year1 215000 33% 70950 144050 28380
Year2 144050 45% 64823 79228 25929
Year3 79228 15% 11884 67343 4754
Year4 67343 7% 4714 62629 1886

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