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?
Answer:
| 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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