Damon Corporation, a sports equipment manufacturer, has a machine currently in use that was originally purchased 3 years ago for $120,000. The firm depreciates the machine under MACRS using a 5-year recovery period. Once removal and cleanup costs are taken into consideration, the expected net selling price for the present machine will be $70,000. Damon can buy a new machine for a net price of $160,000 (including installation costs of $15,000).
The proposed machine will be depreciated under MACRS using a 5-year recovery period. If the firm acquires the new machine its working capital needs will change: Accounts receivable will increase $15,000, inventory will increase $19,000, and accounts payable will increase $16,000.
Earnings before depreciation, interest, and taxes (EBDIT) for the present machine are expected to be $95,000 for each of the successive 5 years. For the proposed machine, the expected EBDIT for each of the next 5 years are $105,000, $110,000, $120,000, $120,000, and $120,000, respectively. The corporate tax rate (T) for the firm is 40%.
Damon expects to be able to liquidate the proposed machine at the end of its 5-year usable life for $24,000 (after paying removal and cleanup costs). The present machine is expected to net $8,000 upon liquidation at the end of same period. Damon expects to recover its net working capital investment upon termination of the project. The firm is subject to a tax rate of 40%.
REQUIRED:
Create a spreadsheet:
to calculate the initial investment.
to prepare a depreciation schedule for both the proposed and the present machine. Both machines are depreciated under MACRS using a 5-year recovery period. Remember that the present machine has only 3 years of depreciation remaining.
to calculate the operating cash flows for Damon corporation for both the proposed and the present machine.
to calculate the terminal cash flow associated with the project.
Question Data:
Original purchase price 3 years ago $120,000
Net selling price of the existing machine $70,000
Cost of new machine (including installation costs) $160,000
Installation costs $15,000
Salvage value of new machine (after 5 years) $24,000
Salvage value of existing machine (after 5 years) $8,000
Changes to working capital:
Increase in accounts receivable $15,000
Increase in inventory $19,000
Increase in account payable $16,000
EBDIT for the present machine next 5 years $95,000
EBDIT for the proposed machine for next five years:
1 $105,000
2 $110,000
3 $120,000
4 $120,000
5 $120,000
Tax 40%
Depreciation MACRS 5-year recovery
MACRS 5-year Table
Recovery year Percentage recovery
1 20%
2 32%
3 19%
4 12%
5 12%
6 5%
Please find below the spreadsheet for the given data:
|----------------------|------------------|-----------------|-----------------|-----------------|-----------------|-----------------|
| | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|----------------------|------------------|-----------------|-----------------|-----------------|-----------------|-----------------|
| Initial Investment | | | | | | |
| Original Purchase | $120,000 | | | | | |
| Installation Costs | $15,000 | | | | | |
| Total Initial | $135,000 | | | | | |
| Investment | | | | | | |
|----------------------|------------------|-----------------|-----------------|-----------------|-----------------|-----------------|
| Depreciation | | | | | | |
| Present Machine | 20% | 32% | 19% | | | |
| Proposed Machine | 20% | 32% | 19% | 12% | 12% | 5% |
|----------------------|------------------|-----------------|-----------------|-----------------|-----------------|-----------------|
| Operating Cash Flows | | | | | | |
| Present Machine | | | | | | |
| Year 1 | $95,000 | | | | | |
| Year 2 | $95,000 | | | | | |
| Year 3 | $95,000 | | | | | |
| Year 4 | $95,000 | | | | | |
| Year 5 | $95,000 | | | | | $8,000 |
| Proposed Machine | | | | | | |
| Year 1 | $105,000 | | | | | |
| Year 2 | $110,000 | | | | | |
| Year 3 | $120,000 | | | | | |
| Year 4 | $120,000 | | | | | |
| Year 5 | $120,000 | | | | | $24,000 |
|----------------------|------------------|-----------------|-----------------|-----------------|-----------------|-----------------|
| Terminal Cash Flow | | | | | | |
| Present Machine | | | | | | $8,000 |
| Proposed Machine | | | | | | $24,000 |
| Net Working Capital | $14,000 (15-1-16) | | | | | |
| Termination Cash Flow| $14,000 | | | | | $14,000 |
|----------------------|------------------|-----------------|-----------------|-----------------|-----------------|-----------------|
Note: The above spreadsheet includes the calculations for the initial investment, depreciation schedule, operating cash flows, and terminal cash flow for both the present and proposed machines. The figures in the spreadsheet are based on the given data and formulae.
To calculate the initial investment, we need to consider the cost of the new machine, installation costs, the salvage value of the existing machine, and the changes in working capital.
The initial investment can be calculated as follows:
Cost of new machine + Installation costs + Net selling price of existing machine - Salvage value of new machine - Changes in working capital
$160,000 + $15,000 + $70,000 - $24,000 - ($15,000 + $19,000 - $16,000)
$160,000 + $15,000 + $70,000 - $24,000 - $18,000
$203,000
Next, let's prepare the depreciation schedule for both the proposed and the present machine. Since both machines are depreciated under MACRS using a 5-year recovery period, we will use the given MACRS 5-year recovery table.
Depreciation for the present machine:
Year 1: $120,000 x 20% = $24,000
Year 2: $120,000 x 32% = $38,400
Year 3: $120,000 x 19% = $22,800
Depreciation for the proposed machine:
Year 1: $160,000 x 20% = $32,000
Year 2: $160,000 x 32% = $51,200
Year 3: $160,000 x 19% = $30,400
Year 4: $160,000 x 12% = $19,200
Year 5: $160,000 x 12% = $19,200
Next, let's calculate the operating cash flows for Damon Corporation for both the proposed and the present machine. The operating cash flows are calculated by subtracting the depreciation expense from the earnings before depreciation, interest, and taxes (EBDIT).
Operating cash flows for the present machine:
Year 1: $95,000 - $24,000 = $71,000
Year 2: $95,000 - $38,400 = $56,600
Year 3: $95,000 - $22,800 = $72,200
Operating cash flows for the proposed machine:
Year 1: $105,000 - $32,000 = $73,000
Year 2: $110,000 - $51,200 = $58,800
Year 3: $120,000 - $30,400 = $89,600
Year 4: $120,000 - $19,200 = $100,800
Year 5: $120,000 - $19,200 = $100,800
Finally, let's calculate the terminal cash flow associated with the project. The terminal cash flow is the sum of the salvage value of the machine and the recovery of net working capital.
Terminal cash flow = Salvage value of new machine + Recovery of net working capital
Terminal cash flow = $24,000 + ($15,000 + $19,000 - $16,000)
Terminal cash flow = $24,000 + $18,000
Terminal cash flow = $42,000
In summary:
The initial investment is $203,000.
The depreciation schedule for the present machine is as follows:
Year 1: $24,000
Year 2: $38,400
Year 3: $22,800
The depreciation schedule for the proposed machine is as follows:
Year 1: $32,000
Year 2: $51,200
Year 3: $30,400
Year 4: $19,200
Year 5: $19,200
The operating cash flows for Damon Corporation for the present machine are:
Year 1: $71,000
Year 2: $56,600
Year 3: $72,200
The operating cash flows for Damon Corporation for the proposed machine are:
Year 1: $73,000
Year 2: $58,800
Year 3: $89,600
Year 4: $100,800
Year 5: $100,800
The terminal cash flow associated with the project is $42,000.