Company XYZ is considering investing in a new machine that w

Company XYZ is considering investing in a new machine that will cost $15,000. The machine will allow the firm to generate sales of $50,000 per year. The machine will have a life of 3 years. The operating expenses of XYZ are projected to be 70% of total sales. The machine will be depreciated on a straight-line basis to a zero salvage value. The market value of the machine in three years is estimated to be $5,000. The marginal tax rate of the firm is 35%. If the discount rate is 20%, should the investment be undertaken?

Solution

Should the investment be undertaken or not, it will depend on the Net Present value. Net Present Value is the present value of cash flow from such investment.It is a measure of proposals. Step-1:Present value of annual cash flow Years 1 2 3 Total Sales $         50,000 $      50,000 $    50,000 Less:operating expenses@70% of sales $         35,000 $      35,000 $    35,000 Less:Depreciation expenses $          5,000 $       5,000 $     5,000 Earning before tax $         10,000 $      10,000 $    10,000 Less:Tax expenses $          3,500 $       3,500 $     3,500 Net Profit $          6,500 $       6,500 $     6,500 add:Depreciation expenses $          5,000 $       5,000 $     5,000 Cash flow $         11,500 $      11,500 $    11,500 Discount factor              0.833           0.694         0.579 Present value $          9,583 $       7,986 $     6,655 $ 24,225 Working; Depreciaion expenses = (Cost-salve Value)/Useful Life = (15000-0)/3 = $       5,000 Step-2:Present value of after tax sale of machine After tax sale value = $       5,000 *(1-0.35) = $       3,250 since cost of machine has been depreciated, Book value will be zero and all the sale proceeds will become gain on sale and so all amout is taxed. Present value of after tax sale proceeds of machine = $     3,250 *      0.579 = $     1,881 Step-3:Total present value of cash inflow Present value of annual cash flow $      24,225 Present value of machine $       1,881 Total Present value of cash inflow $      26,105 Step-4:Calculatig Net Present value Present value of cash inflow $      26,105 Less:Initial investent $      15,000 Net Present Value $      11,105 Since there is positive net present value , investment should be undertaken.