For a new project of a company to reduce production costs, the COO, suggests replacing one of its manufacturing equipment with a newer, more efficient model.This four year project will result in reduced manufacturing costs which, in turn, would allow Automation to reduce the price of its flagship AI CalcPro IV.The COO believes reducing the cost of the processor will better position Automation to compete with AI-CHIP.

The current equipment, a MAC-98, can be sold today for $1,000,000 net.A brand-new MAC-125 retails for almost $3,250,000; however, the COO believes she can purchase it for $3,000,000.She intends to fund this purchase in part with proceeds from the sale of the MAC-98.In addition, accounts payable are expected to increase by $1,500,000 today, and fully reverse in year 4.

The new equipment will be in operation beginning in year two.As the old equipment will be offline in year 1, the COO forecasts lost revenues of $550,000 in year 1.The cost savings in years 2, 3 and 4 are estimated at $600,000, $950,000, and $1,000,000, respectively.Automaton's cost of capital and tax-rate remain unchanged.

The project manager is particularly excited about this project and goes about evaluating it.He is a bit unclear about how changes in depreciation impact FCFs, and seeks guidance from the COO.The COO makes the following comment (1^st comment): "All else equal, higher depreciation expenses will result in larger FCF and lower net income.(2^nd comment)The specific impact can be discerned by multiplying the incremental depreciation expense by tax rate."

Questions

1.What is the initial outlay for this project?

2.What is this project's FCF for years 1 through 4?

3.What is this project's NPV?

4.The project manager is concerned that the estimated cost of capital is too high.He adjusts Beta and computes a new cost of capital of 5%.Using this, what is this project's NPV?

5.Is the COO's comment on the relationship between depreciation and FCFs and net income accurate?Discuss briefly.

6.Is the COO's second comment accurate?Discuss briefly.

Exhibits

MACRS 5 Schedule

Year 1: 20%

Year 2: 32%

Year 3: 19.2%

Year 4: 11.52%

Year 5: 11.52%

Cost of Capital

WACC =

Cost of Equity = Risk-Free Rate + *(Equity Risk Premium)

After-Tax Cost of Debt = (1-Tax Rate) * Pre-Tax Cost of Debt

Risk-Free Rate (10-Year U.S. Treasury) = 3%

The Equity Risk Premium = 4.5%

Tax Rate: 40%

Automaton's beta () = 1.2

Automaton's Market Value of Equity / Total Capital ratio = 100%

Automaton's Market Value of Debt / Total Capital = 0%