Caradoc Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $560,000 is estimated to result in $210,000 in annual pre-tax cost savings. The press falls into Class 8 for CCA purposes (CCA rate of 20 percent per year), and it will have a salvage value at the end of the project of $80,000. The press also requires an initial investment in spare parts inventory of $20,000, along with an additional $3,000 in inventory for each succeeding year of the project. If the shop's tax rate is 35 percent and its discount rate is 9 percent, should Caradoc buy and install the machine press?
To evaluate whether Caradoc should buy and install the machine press, we need to calculate the net present value (NPV) of the project.
1. Calculate the annual tax savings:
Annual tax savings = Annual pre-tax cost savings * Tax rate
Annual tax savings = $210,000 * 0.35
Annual tax savings = $73,500
2. Calculate the annual cash flow:
Annual cash flow = Annual pre-tax cost savings - Annual tax savings
Annual cash flow = $210,000 - $73,500
Annual cash flow = $136,500
3. Calculate the CCA tax shield:
CCA tax shield = Initial investment * CCA rate
CCA tax shield = $560,000 * 0.20
CCA tax shield = $112,000
4. Calculate the after-tax salvage value:
After-tax salvage value = Salvage value - CCA tax shield on salvage value
After-tax salvage value = $80,000 - ($80,000 * 0.20)
After-tax salvage value = $80,000 - $16,000
After-tax salvage value = $64,000
5. Calculate the initial investment:
Initial investment = Machine press cost + Spare parts inventory
Initial investment = $560,000 + $20,000
Initial investment = $580,000
6. Calculate the annual cash flow after tax savings:
Annual cash flow after tax savings = Annual cash flow + Additional inventory cost
Annual cash flow after tax savings = $136,500 + ($3,000 * (project years - 1))
Annual cash flow after tax savings = $136,500 + ($3,000 * (4 - 1))
Annual cash flow after tax savings = $145,500
7. Calculate the NPV using the discount rate (9%):
NPV = Initial investment + (Annual cash flow after tax savings / (1 + discount rate)^year) - After-tax salvage value / (1 + discount rate)^year
NPV = $580,000 + ($145,500 / (1 + 0.09)^1) + ($145,500 / (1 + 0.09)^2) + ($145,500 / (1 + 0.09)^3) + ($145,500 / (1 + 0.09)^4) - $64,000 / (1 + 0.09)^4
8. Calculate the NPV using the above formula:
Year 1: $580,000 + ($145,500 / (1 + 0.09)^1) - $64,000 / (1 + 0.09)^1 = $580,000 + $133,486.24 - $58,715.59 = $654,770.65
Year 2: $580,000 + ($145,500 / (1 + 0.09)^2) - $64,000 / (1 + 0.09)^2 = $580,000 + $122,335.77 - $53,848.31 = $648,488.45
Year 3: $580,000 + ($145,500 / (1 + 0.09)^3) - $64,000 / (1 + 0.09)^3 = $580,000 + $112,484.03 - $49,537.76 = $643,946.27
Year 4: $580,000 + ($145,500 / (1 + 0.09)^4) - $64,000 / (1 + 0.09)^4 = $580,000 + $103,619.16 - $45,682.52 = $640,936.64
NPV = $654,770.65 + $648,488.45 + $643,946.27 + $640,936.64 - $64,000
NPV = $2,523,141.01 - $64,000
NPV = $2,459,141.01
Since the NPV is positive ($2,459,141.01), Caradoc should buy and install the machine press. A positive NPV indicates that the project is expected to generate more value than its costs, making it financially viable.