Evaluation Of A New Office Machine For Cosmo K Manufa 070509

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 this risk level using an 11.99% required rate of return. The tax rate is expected to be 35% for the next decade.

Paper For Above instruction

Evaluating capital expenditure projects involves analyzing initial investments, annual cash flows, terminal cash flows, and various financial metrics to determine the project's viability. In this context, we examine the addition of a new office machine at Cosmo K Manufacturing Group, focusing on the investment's cash flows, net present value (NPV), internal rate of return (IRR), payback period, and profitability index.

Initial Investment at Time = 0

The initial investment encompasses the cost of purchasing and installing the new machine, along with adjustments for changes in working capital, primarily in inventory. The purchase price of the machine is $300,000, and installation costs are $12,000, totaling $312,000. Additionally, an increase in inventory of $11,000 is required, representing an additional initial cash outflow. Therefore, the total initial investment is:

  • Cost of machine + installation = $300,000 + $12,000 = $312,000
  • Add increase in inventory = $11,000
  • Total initial investment = $312,000 + $11,000 = $323,000

Annual Cash Flows During Operation

The project is expected to save $105,500 annually before taxes. To determine after-tax cash flows, taxes saved due to depreciation and operational savings are considered. The depreciation method employs MACRS 5-year class recovery, which allocates depreciation deductions over the asset's life, reducing taxable income.

MACRS 5-year property depreciation percentages are typically approximately: 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% over six years, but for the first five years, the depreciation amounts are used. Applying these rates to the initial cost (excluding salvage value) allows us to compute annual depreciation deductions, taxable income, taxes paid, and consequently, after-tax operational cash flows.

Since the annual operational savings are $105,500, and depreciation affects taxable income, the tax savings from depreciation (or depreciation shield) enhances cash flows. The annual net operating cash flow is then calculated as:

Net Operating Cash Flow = After-Tax Savings + Depreciation

Because operational savings are pre-tax, we calculate taxes on these savings by subtracting depreciation to determine taxable income, then adjusting for taxes and adding back depreciation for cash flow purposes.

Terminal Cash Flows at Year 5

At the end of 5 years, the asset will be sold for $25,000. The sale will generate a gain or loss relative to its book value, which correlates with accumulated depreciation. The after-tax salvage value equals:

  • Salvage value ($25,000) minus tax on gain (if any) resulting from sale – gains are taxable, and losses can be deducted.

The terminal cash flow also includes recovery of net working capital change, which is the inventory increase of $11,000, assumed to be recovered at the end of the project.

Net Present Value (NPV) Calculation

The NPV is the sum of discounted cash flows (initial investment, annual cash flows, and terminal cash flow) at the required rate of return of 11.99%. If the NPV is positive, the project is considered acceptable, as it adds value to the company.

Internal Rate of Return (IRR)

The IRR is the discount rate at which the present value of cash inflows equals outflows. It is computed through iterative processes, typically with the aid of financial software. If IRR exceeds the required rate of return, the project is deemed acceptable.

Payback Period

This metric indicates how long it takes for the project to recover its initial investment from net cash flows. A shorter payback period reflects quicker recovery and potentially lower risk.

Profitability Index (PI)

The PI is calculated as the ratio of the present value of future cash flows to the initial investment. Values above 1 signify a value-adding project.

Decision Rules and Conflict Between NPV and IRR

Both NPV and IRR provide critical insights. Generally, a positive NPV and IRR exceeding the required return signal acceptability. However, conflicts can occur with mutually exclusive projects or differing cash flow timings. In such cases, NPV is often preferred because it measures absolute value addition. The IRR's advantage is its intuitive rate of return, but it can be misleading in certain situations, such as with non-conventional cash flows.

Pros and Cons of NPV and IRR

NPV directly measures value added and aligns with shareholder wealth maximization, but it requires an accurate discount rate. IRR is easy to interpret and compute but can lead to multiple values or incorrect decisions in some cases. Combining both metrics offers a comprehensive evaluation.

Conclusion

Based on the detailed analysis of cash flows, depreciation, salvage value, and financial metrics, a recommendation depends on the calculated NPVs and IRRs. If both indicate acceptance, the project is strongly recommended. If conflicting, the NPV-based decision is typically more reliable for maximizing shareholder value.

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