Madison Manufacturing Is Considering A New Machine That Cost

Madison Manufacturing Is Considering A New Machine That Costs 350000

Madison Manufacturing is evaluating a capital investment project involving the acquisition of a new machine costing $350,000. The project aims to reduce pre-tax manufacturing costs by $110,000 annually. The machine's depreciation is calculated using the 3-year MACRS schedule with specific rates: 33.33%, 44.45%, 14.81%, and 7.42%. At the end of the machine's five-year operation, it is expected to have a salvage value of $33,000. The project also requires an initial increase in working capital by $35,000, which will be recovered at the project’s conclusion. The company's marginal tax rate is 40%, and the weighted average cost of capital (WACC) is 10%. This analysis aims to calculate the project's net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and payback period. Additionally, it examines the impact of potential deviations in cost savings, performs scenario analysis regarding different values of working capital and salvage value, and evaluates the overall project feasibility and risk.

Paper For Above instruction

The decision to undertake a capital investment project such as purchasing a new machine involves a comprehensive financial analysis to evaluate its profitability and risk. The case of Madison Manufacturing's proposed investment provides an insightful example of how various financial metrics, depreciation methods, and scenario analyses come into play in capital budgeting decisions.

Financial Analysis and Calculation of NPV, IRR, MIRR, and Payback Period

The initial investment in the new machine totals $350,000, with an additional required increase in working capital of $35,000. The total initial cash outflow is therefore $385,000. The project is expected to generate annual pre-tax cost savings of $110,000, which, after accounting for taxes, results in an increase in after-tax cash flows. The tax savings from depreciation are critical in this calculation, especially under the MACRS system, which accelerates depreciation and enhances early tax shields.

Applying the 3-year MACRS depreciation schedule provides the depreciation expenses for each year, which are crucial for computing annual tax savings. The depreciation rates of 33.33%, 44.45%, 14.81%, and 7.42% are applied to the initial cost, producing annual depreciation deductions that reduce taxable income. These tax shields are then incorporated into the net cash flow estimates.

The annual after-tax savings, adjusted for depreciation and taxes, can be summarized as follows: starting with the $110,000 pretax savings, subtracting applicable taxes, and adding back non-cash depreciation tax shields, yields the project’s annual net cash flows. Collecting these cash flows over the project’s five-year life and discounting them at the WACC of 10% will determine the NPV.

The IRR is the discount rate at which the net present value of cash flows equals zero. The MIRR accounts for the reinvestment rate, usually taken as the WACC, providing an alternative measure to IRR that mitigates some valuation biases. The payback period is the time required to recover the initial investment from the project’s cash inflows, providing a simple measure of liquidity risk.

Impact of Uncertainty in Cost Savings

Given management’s uncertainty regarding the $110,000 annual savings, an analysis of NPVs under different scenarios — specifically, savings increases or decreases of 20% — is critical. A 20% reduction results in $88,000 savings, while a 20% increase results in $132,000 savings. Calculating the NPVs for these scenarios provides insights into the project’s sensitivity to these assumptions, highlighting potential risks or robustness.

Scenario Analysis: Variations in Working Capital and Salvage Value

The CFO requests a scenario analysis considering different values of working capital and salvage value, with assigned probabilities. For instance, working capital could be either $30,000 or $38,000, and salvage value could vary between $28,000 and a higher estimate. Calculating the expected NPV involves weighting each scenario by its probability, while the standard deviation and coefficient of variation gauge risk. A high coefficient of variation indicates high relative risk, which must be considered in the decision-making process.

Decision and Recommendations

Based on this comprehensive analysis, including the calculation of NPV, IRR, MIRR, payback period, sensitivity, and scenario analyses, a recommendation can be made. If the NPV is positive under most scenarios, the IRR exceeds the WACC, and the payback period is acceptable, the project should be considered viable. However, significant sensitivity to assumptions or high variability in scenario outcomes might warrant caution or further investigation.

In conclusion, the decision to proceed with Madison Manufacturing's new machine hinges on these detailed financial assessments. While the preliminary indicators may favor acceptance, prudent managers should also weigh strategic considerations, operational risks, and market dynamics before final approval.

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