Question
Maddux, Inc. is planning to purchase equipment worth $400,000. Delivery and setup costs will amount to $20,000. In addition, $25,000 in net working capital will
- Maddux, Inc. is planning to purchase equipment worth $400,000. Delivery and setup costs will amount to $20,000. In addition, $25,000 in net working capital will be required at installation. The equipment will have a 5 year class life and will be depreciated using simplified straight line. Maddux has a marginal tax rate of 21% and a cost of capital of 12 percent.
The new equipment will increase the firms revenues by $220,000 per year, decrease defects costs by $10,000 per year, and increase operating costs by $30,000 per year.
a. Suppose Maddux keeps the equipment for 3 years and sells it for $200,000. What are the projects IRR and NPV?
Step 1: Initial Outlay
New equipment cost | -400,000 |
Shipping & Installation | + 20,000 |
Depreciable cost | = $420,000 |
Investment in NWC (not depreciable) | + 25,000 |
Net initial outlay | = $445,000 |
Book value is 84,000 (420,000/5 = 84,000)
84,000 x 2 = 168, 000
Step 2: Incremental cash flows:
Increased revenue | 220,000 |
Increased operating costs | - 30,000 |
Decreased defects | +10,000 |
Increased depreciation | - 84,000 |
EBT | = 116,000 |
Taxes (21%) | - 24,360 |
EAT | = 91,640 |
Depreciation reversal | + 84,000 |
Annual cash flows | = 175,640 |
Step 3: Terminal Cash Flow:
Which is a cash flow | ||
Book Value | 168,000 | No |
Capital gain/loss | 200,000 - 168,000 = 32,000 | No |
Tax refund | 32,000 x 21% = - 6,720 | Yes, coming back (because it is capital loss carried back 3 years or carried forward up to 5 years) |
Recapture of NWC | + 25,000 | |
Terminal cash flow | 218,280 |
200,000 Salvage value
-6720 tax on capital gain
+ 25,000 recapture of NWC
218,280 terminal cash flow
NPV and IRR:
CFj (0) = - 445,000
CFj (1-2) = 175,640
CFj (3) = 218,280 (terminal cash flow) + 175,640 (annual cash flow for year 3) = 393,920
Discount rate = 12% IRR = 26.25%
NPV = $132,225.04 accept the project
b. Suppose Maddux can only get $100,000 for the equipment after 3 years due to the rapidly changing technology. What are the projects IRR and NPV?
Which is a cash flow | ||
Book Value | 168,000 | No |
Capital gain/loss | 100,000 - 168,000 = -68,000 | No |
Tax refund | 68,000 x 21% = + 14,280 | Yes, coming back (because it is capital loss carried back 3 years or carried forward up to 5 years) |
Recapture of NWC | + 25,000 | |
Terminal cash flow | 139,280 |
100,000 Salvage value
+ 14,280 tax on capital gain
+ 25,000 recapture of NWC
= 139,280 terminal cash flow
I have solved for part a and some of part b but I am not getting the correct answer for NPV or IRR on part B can someone help me solve rest of part B
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