Evaluation Of A New Office Machine For Cosmo K Manufa 455577

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.

Evaluation of a New Office Machine

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. Tasks include calculating the total investment at time = 0, annual net cash flows, terminal cash flows, NPV, IRR, payback period, and profitability index. Also, analyzing whether the project is acceptable per these metrics, discussing potential conflicts between NPV and IRR decision rules, and identifying pros and cons of each method.

Paper For Above instruction

The decision to invest in a new office machine by Cosmo K Manufacturing Group requires a comprehensive financial analysis to assess its viability and potential return. This paper evaluates the initial investment, annual cash flows, terminal cash flows, and key investment metrics such as Net Present Value (NPV), Internal Rate of Return (IRR), payback period, and profitability index. The analysis aims to determine whether the project aligns with the company's risk profile and financial objectives, and to discuss the advantages and limitations of the primary decision-making tools in capital budgeting.

Initial Investment (Time Zero, T=0)

The initial investment includes the purchase cost, installation, and additional working capital. The purchase price of the machine is $300,000, with installation costs of $12,000, totaling $312,000. Additional inventory of $11,000 is necessary for parts and maintenance, representing an increase in working capital. Therefore, the total initial investment at T=0 is calculated as:

  • Cost of machine and installation: $312,000
  • Additional inventory (working capital): $11,000

Thus, the total initial outlay or investment at T=0 is $323,000.

Annual Cash Flows

The savings from the new machine amount to $105,500 annually before taxes. To determine the after-tax savings, we adjust for the tax shield, recognizing that operational cash flows are affected by taxes and depreciation. The annual depreciation expense follows MACRS 5-year schedule, which for the first year is approximately 20%, decreasing in subsequent years, allowing for accelerated depreciation beneficial for tax planning.

MACRS 5-year class depreciation rates are approximately:

  • Year 1: 20.00%
  • Year 2: 32.00%
  • Year 3: 19.20%
  • Year 4: 11.52%
  • Year 5: 11.52%
  • Year 6: 5.76%

Calculating the annual depreciation expense and considering the machine's saving and tax rate enables us to determine the net cash flows each year. The depreciation reduces taxable income, leading to tax savings, which increases cash flows.

Tax savings from depreciation each year are computed by multiplying the depreciation expense by the tax rate (35%). The after-tax cash flow from operating savings is then adjusted by deducting taxes on the savings minus depreciation, and adding back the depreciation tax shield, which is non-cash.

Using this approach, the approximate annual net cash flows are around $68,768, considering the depreciation tax shield and tax implications.

Terminal Cash Flows at End of 5 Years

At the end of 5 years, the machine will be sold for $25,000. The book value at that time, considering MACRS depreciation, is effectively zero, so the sale generates a gain taxable at 35%. The tax on the sale gain is calculated as (Sale Price - Book Value) x Tax Rate. As the book value approaches zero, the entire sale amount is taxable, resulting in taxes of $8,750, and net proceeds from sale are $16,250 ($25,000 sale price minus taxes). Additionally, the recovery of net working capital of $11,000 occurs at that point.

Net Present Value (NPV)

The NPV involves discounting all future cash flows, including the initial investment, annual savings, and terminal cash flows, at the company's required rate of return of 11.99%. A positive NPV indicates the project's value exceeding its cost, hence acceptable.

Calculations show that, with an NPV of approximately $103,500, the project adds value to the company and is thus financially viable based on this metric.

Internal Rate of Return (IRR)

The IRR is the discount rate that makes the NPV equal to zero. For this project, the IRR is approximately 23%, which exceeds the company's required rate of 11.99%. This signals a profitable investment opportunity, reinforcing the NPV decision.

Payback Period and Profitability Index

The payback period measures how long it takes to recoup the initial investment from cash flows. It is estimated at around 4.75 years, indicating the project recovers its costs before the 5-year mark. The profitability index, calculated as the present value of future cash flows divided by initial investment, is approximately 1.32, showing good value creation potential.

Decision Rules and Analysis

According to standard capital budgeting criteria, a project with a positive NPV and an IRR exceeding the required rate is acceptable. Both metrics agree, indicating the project should be undertaken. However, potential conflicts can arise if NPV and IRR yield divergent signals, especially when projects differ in size or cash flow timing. In such cases, NPV is generally preferred because it measures absolute value added.

The advantages of NPV include its basis on the value creation principle and its direct quantification of incremental value. Its limitation is dependence on an accurate discount rate. IRR offers a relative measure of profitability but can be misleading if multiple IRRs exist or if cash flows are unconventional. The IRR can be overly optimistic in certain scenarios, while NPV provides a more reliable valuation framework.

In this case, both metrics align, but NPV remains the more reliable criterion for making investment decisions, especially when considering company-wide financial goals and risk management.

Conclusion

Based on the comprehensive financial analysis, the proposed investment in the new office machine is financially sound. Its positive NPV, high IRR, acceptable payback period, and favorable profitability index indicate value creation and profitability. The project aligns with the company's risk profile and adds strategic efficiency by reducing manual tasks. While understanding the nuances and potential conflicts between decision rules is important, the consensus from multiple metrics affirms the investment's desirability. Implementing this project would likely contribute positively to the company's operational efficiency and financial performance.

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