As the investment analyst for King breweries you are required to analyze the automated loom system in the Castle larger production line. The old system was purchased 5 years ago for $200,000. It falls in the accelerated cost recovery 5 year class and it has 5 years of remaining life and $50,000 salvage value 5 yeas from now.The current market value for the old system is $100,000. The new machine has a price of $300,000, plus an additional $50,000 in installation costs. the new system falls into the accelerated recovery class(depreciation) 5 year class,has a five year economic life and a $100,000 salvage value. The new system will require a $40,000 increase in the spare parts inventory. The primary advantage of the new machine is that it will decrease opening costs by $40,000 per year. The required rate of return is 12% with a marginal tax rate of 34%.
calculate
1. the initial investment outlay in year0.
2. What are the incremental cash flow in year 1.
3. What is the net cash flow in the final year(year 5.
4. What is the net present value of the project.
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To calculate the various financial metrics for the project, we need to assess each component and cash flow involved. Let's break down each question and calculate the required values step by step:
1. To determine the initial investment outlay in year 0, we need to consider the cost of the new machine, installation costs, and the increase in spare parts inventory:
- Cost of new machine: $300,000
- Installation costs: $50,000
- Increase in spare parts inventory: $40,000
- Initial investment outlay = Cost of new machine + Installation costs + Increase in spare parts inventory
- Initial investment outlay = $300,000 + $50,000 + $40,000
- Initial investment outlay in year 0 = $390,000
2. To calculate the incremental cash flow in year 1, we need to consider the decrease in operating costs and the tax savings resulting from depreciation:
- Decrease in operating costs: $40,000
- Tax savings from depreciation: Depreciation expense * Tax rate
- Depreciation expense = (Cost of new machine - Salvage value) / Useful life
- Depreciation expense = ($300,000 - $100,000) / 5
- Depreciation expense = $40,000
- Tax savings from depreciation = Depreciation expense * Tax rate
- Tax savings from depreciation = $40,000 * 0.34
- Tax savings from depreciation = $13,600
- Incremental cash flow in year 1 = Decrease in operating costs + Tax savings from depreciation
- Incremental cash flow in year 1 = $40,000 + $13,600
- Incremental cash flow in year 1 = $53,600
3. To determine the net cash flow in the final year (year 5), we need to consider the salvage value and the tax savings resulting from depreciation:
- Salvage value = $100,000
- Tax savings from depreciation (last year):
- Depreciation expense = (Cost of new machine - Salvage value) / Useful life
- Depreciation expense = ($300,000 - $100,000) / 5
- Depreciation expense = $40,000
- Tax savings from depreciation = Depreciation expense * Tax rate
- Tax savings from depreciation = $40,000 * 0.34
- Tax savings from depreciation = $13,600
- Net cash flow in the final year = Salvage value + Tax savings from depreciation
- Net cash flow in the final year = $100,000 + $13,600
- Net cash flow in the final year (year 5) = $113,600
4. To calculate the net present value (NPV) of the project, we need to discount each year's cash flow at the required rate of return (12%) and consider the initial investment outlay as a cash outflow in year 0:
- Discounted cash flows for each year:
- Year 0: -$390,000 (Initial investment outlay)
- Year 1: $53,600
- Year 2: $53,600
- Year 3: $53,600
- Year 4: $53,600
- Year 5: $113,600
- Calculate the present value (PV) for each cash flow using the following formula:
- PV = Cash flow / (1 + r)^t, where r is the discount rate and t is the time period
- Calculate the NPV by summing up the present values of all cash flows:
- NPV = PV(Year 0) + PV(Year 1) + PV(Year 2) + PV(Year 3) + PV(Year 4) + PV(Year 5)
By applying the formulas mentioned above and substituting the values, you will be able to calculate the NPV of the project.