Fn3440 Week 5 Leverage And Cash Flows Analysis: New Project

Fn3440 Week 5 Leverage And Cash Flowsanalysis 51new Project Analysis

FN3440: Week 5 Leverage and Cash flows Analysis 5.1 New Project Analysis 1 The Chung Chemical Corporation is considering the purchase of a chemical analysis machine. Although the machine being considered will result in an increase in earnings before interest and taxes of $35,000 per year, it has a purchase price of $100,000, and it would cost an additional $5,000 to properly install the machine. In addition, to properly operate the machine, inventory must be increased by $5,000. This machine has an expected life of 10 years, after which it will have no salvage value. Also, assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 15 percent.

Answer the following questions:

1. What is the initial outlay associated with this project?
2. What are the annual after-tax cash flows associated with this project for years 1 through 9?
3. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with the termination of the project)?
4. Should this machine be purchased?

Paper For Above instruction

The decision to purchase new equipment involves a comprehensive financial analysis, which includes calculating initial investment costs, annual cash flows, and considering the terminal cash flow at the end of the equipment’s useful life. This paper carefully evaluates the project proposed by Chung Chemical Corporation, scrutinizing the relevant financial aspects to determine whether the investment is justified.

Initial Outlay Calculation

The initial outlay encompasses all costs associated with acquiring and preparing the machine for operation. The purchase price of the machine is $100,000, and an additional cost of $5,000 is required for proper installation. Furthermore, the increase in working capital—specifically inventory—amounts to $5,000, representing an immediate cash outflow necessary to support operation. Thus, the total initial investment can be summarized as follows:

• Machine purchase price: $100,000
• Installation costs: $5,000
• Increase in working capital (inventory): $5,000

Therefore, the initial outlay equals $100,000 + $5,000 + $5,000 = $110,000.

Annual After-Tax Cash Flows (Years 1-9)

To determine the annual after-tax cash flows, we start with the incremental earnings before interest and taxes (EBIT), which is given as $35,000 annually. Since the project involves depreciation, which reduces taxable income, we calculate depreciation expense and then compute taxes accordingly.

Depreciation expense is calculated via straight-line depreciation over 10 years:

Depreciation = Cost of the machine / Useful life = ($100,000 + $5,000) / 10 = $105,000 / 10 = $10,500 per year.

This depreciation expense reduces taxable income, leading to tax savings. The taxable income is:

EBIT - Depreciation = $35,000 - $10,500 = $24,500.

Taxes = Tax rate x taxable income = 34% x $24,500 ≈ $8,330.

Net income after taxes = $24,500 - $8,330 ≈ $16,170.

However, when calculating cash flows, we add back depreciation because it is a non-cash expense:

Annual after-tax cash flow = Net income + Depreciation = $16,170 + $10,500 ≈ $26,670.

It's worth noting that, since working capital increase is an initial outlay, it impacts cash flows only at the project's start and end, not annually during operation.

Terminal Cash Flow in Year 10

At the end of year 10, the project concludes, and we consider the salvage value of the asset, which is zero in this case. However, recovery of working capital is a crucial component; the $5,000 initially invested in inventory will be recovered. Additionally, since the equipment has no salvage value, there are no residual cash flows from the sale of the asset.

Thus, the terminal cash flow includes:

• Annual after-tax cash flow in year 10: ≈ $26,670
• Recovery of working capital: $5,000

Total terminal cash flow = $26,670 + $5,000 = $31,670.

Decision Analysis and Recommendation

To evaluate whether the project is financially viable, we perform a discounted cash flow analysis using the required return of 15%. The key metric is the Net Present Value (NPV), which accounts for all cash flows discounted to present value.

The initial outlay is $110,000. The annual cash flows of $26,670 occur for 9 years, with the terminal cash flow received in year 10. Using the discount rate of 15%, the present value of these payments is calculated as follows:

• Present value of annual cash flows:

PV = $26,670 × [(1 - (1 + r)^-n) / r] = $26,670 × [(1 - (1 + 0.15)^-9) / 0.15] ≈ $26,670 × 4.160 = $110,974.

• Present value of terminal cash flow:

PV of terminal cash flow = $31,670 / (1 + 0.15)^10 ≈ $31,670 / 4.045 = $7,823.

Adding these present values: $110,974 + $7,823 ≈ $118,797. Comparing this to the initial outlay of $110,000 shows a positive NPV of approximately $8,797, indicating that the project adds value to the company.

Based on this financial analysis, since the NPV is positive and exceeds the required rate of return, it is financially favorable to proceed with the purchase.

In conclusion, considering the initial investment, positive cash flows, and recovered working capital, purchasing the machine aligns with sound financial management principles and should be pursued.

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