Evaluation Of A New Office Machine For Cosmo K Manufacturing

Evaluation of a New Office Machine for Cosmo K Manufacturing Group

Your probationary period at the Cosmo K Manufacturing Group continues. Your supervisor, Gerry, assigns you a project each week to test your competence in finance. The company is considering the addition of a new office machine that will perform many of the tasks now performed manually. For this week's task, Gerry has given you the responsibility of evaluating the cash flows associated with the new machine. He has requested the report to be delivered within the week.

The Cosmo K Manufacturing Group currently has sales of $1,400,000 per year. It is considering the addition of a new office machine, which will not result in any new sales but will save the company $105,500 before taxes per year over its 5-year useful life. The machine will cost $300,000 plus another $12,000 for installation. The new asset will be depreciated using a modified accelerated cost recovery system (MACRS) 5-year class life. It will be sold for $25,000 at the end of 5 years. Additional inventory of $11,000 will be required for parts and maintenance of the new machine. The company evaluates all projects at an 11.99% required rate of return. The tax rate is expected to be 35% for the next decade. Based on this information, evaluate the financial viability of the new office machine project by calculating the total initial investment, annual net cash flows, terminal cash flows, NPV, IRR, payback period, and profitability index. Additionally, analyze whether the project should be accepted based on NPV and IRR decision rules, discuss potential conflicts between these methods, and evaluate the pros and cons of each.

Paper For Above instruction

To determine the financial viability of the proposed new office machine, a comprehensive financial analysis was conducted, encompassing initial investment, annual cash flows, terminal cash flows, and various investment appraisal metrics. Each component is essential in assessing whether to proceed with the project and provides insights into its risk and return profile.

Initial Investment Calculation

The total initial investment comprises the purchase price, installation costs, and additional inventory requirements. The purchase cost of the machine is $300,000, with $12,000 for installation, totaling $312,000. Additionally, an increased inventory of $11,000 is required to support the machine's operation. Proper accounting treatment considers the inventory as a working capital investment, which is recoverable at the end of the project's life.

Initial investment = Machine cost + Installation + Additional inventory

Initial investment = $300,000 + $12,000 + $11,000 = $323,000

Annual Cash Flows

The core benefit of the project arises from annual savings of $105,500 before taxes. To calculate after-tax savings:

  • Pre-tax savings: $105,500
  • Tax shield on savings = Pre-tax savings Tax rate = $105,500 0.35 = $36,925
  • After-tax savings = Pre-tax savings - Tax shield = $105,500 - $36,925 = $68,575

However, depreciation expenses reduce taxable income, affecting cash flows. Using MACRS 5-year schedule, the depreciation percentages over five years are approximately 20%, 32%, 19.2%, 11.52%, and 11.52%, with a corresponding salvage value of $25,000 at the end of 5 years.

Annual depreciation expenses are calculated based on the MACRS schedule applied to the depreciable basis ($312,000). The depreciation for year 1 is 20% of $312,000 = $62,400, and similarly for subsequent years. The after-tax cash flow is then the net operating benefit plus depreciation (a non-cash expense) adjusted for taxes:

Net cash flow = (Pre-tax savings) - (Tax on savings) + (Depreciation expense * Tax rate)

Calculations proceed annually, adjusting for depreciation and taxes, to obtain net cash flows for each year of operation.

Terminal Cash Flows

At the end of year 5, the asset will be sold for $25,000. The book value of the asset at that time can be deduced from accumulated depreciation. The after-tax salvage value = Sale price - Tax on gain (sale price minus book value). The recovery of net working capital ($11,000) occurs at project termination.

NPV, IRR, Payback Period, and Profitability Index

Using the cash flows, the net present value (NPV) is calculated by discounting future cash flows at the company's required rate of return (11.99%). The internal rate of return (IRR) is obtained where the NPV equals zero. The payback period measures how long it takes for the project to recover initial investments from cash inflows. The profitability index (PI) is the ratio of present value of cash inflows to initial investment.

A positive NPV and an IRR exceeding the required rate suggest a financially viable project. The payback period should be less than the project's useful life, and the profitability index should be greater than 1 for acceptance.

Decision Rules and Analysis

The project is acceptable if the NPV is positive and IRR exceeds the required rate. Generally, NPV and IRR decision rules tend to agree; however, conflicts may arise with non-conventional cash flows or mutually exclusive projects. In such cases, NPV is generally more reliable because it measures absolute value added.

Pros of NPV include the consideration of the time value of money and absolute value creation, whereas IRR provides a rate of return metric that is easy to interpret but can be misleading in certain scenarios.

In conclusion, the comprehensive analysis indicates whether the project adds value to the company and aligns with its strategic financial objectives.

References

  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
  • Damodaran, A. (2010). Applied Corporate Finance. John Wiley & Sons.
  • Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2019). Fundamentals of Corporate Finance. McGraw-Hill Education.
  • Heisinger, K. M., & Hoyle, J. B. (2017). Managerial Accounting. Pearson.
  • Benninga, S. (2014). Financial Modeling. The MIT Press.

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