You Have Been Asked By The President And CEO Of Kidd Pharmac

You Have Been Asked By The President And Ceo Of Kidd Pharmaceuticals T

You have been asked by the president and CEO of Kidd Pharmaceuticals to evaluate the proposed acquisition of a new labeling machine for one of the firm’s production lines. The machine’s price is $50,000, and it would cost another $10,000 for transportation and installation. The machine falls into the MACRS three-year class, and hence the tax depreciation allowances are 0.33, 0.45, and 0.15 in Years 1, 2, and 3, respectively. The machine would be sold after three years because the production line is being closed at that time. The best estimate of the machine’s salvage value after three years of use is $20,000.

The machine would have no effect on the firm’s sales or revenues, but it is expected to save Kidd $20,000 per year in before-tax operating costs. The firm’s tax rate is 40 percent and its corporate cost of capital is 10 percent.

Paper For Above instruction

Introduction

The decision to acquire new equipment is critical for firms aiming to enhance operational efficiency and profitability. Kidd Pharmaceuticals' proposal to purchase a labeling machine involves evaluating its financial viability through capital budgeting techniques. This paper examines the project's initial investment, operating cash flows, terminal cash flows, and profitability, considering depreciation, tax implications, and salvage value, to determine whether the project aligns with the company’s strategic and financial goals.

Initial Investment Outlay (Year 0)

The initial investment comprises the purchase price and associated costs necessary to prepare the asset for operation. The purchase price of the labeling machine is $50,000, and transportation and installation costs amount to $10,000. Since these costs are directly attributable to bringing the asset into service, they are capitalized as part of the initial investment.

Therefore, the total initial outlay at Year 0 is:

Initial Investment = Purchase Price + Transport & Installation = $50,000 + $10,000 = $60,000

This outlay represents the cash flow at Year 0, marking the beginning of the project.

Operating Cash Flows (Years 1, 2, and 3)

The new machine is expected to save Kidd $20,000 annually in operating costs before taxes; however, depreciation and tax effects influence the actual cash flows.

Depreciation Calculation:

Using the MACRS three-year class life, depreciation rates are:

- Year 1: 33%

- Year 2: 45%

- Year 3: 15%

The depreciable base for depreciation is the initial cost, which includes the purchase price and installation costs ($60,000).

The annual depreciation expense is:

- Year 1: 0.33 × $60,000 = $19,800

- Year 2: 0.45 × $60,000 = $27,000

- Year 3: 0.15 × $60,000 = $9,000

Tax Savings from Depreciation:

Depreciation reduces taxable income, yielding tax shields:

- Year 1: $19,800 × 40% = $7,920

- Year 2: $27,000 × 40% = $10,800

- Year 3: $9,000 × 40% = $3,600

Pre-Tax Operating Savings:

Annual cost savings: $20,000

Calculating Operating Cash Flows:

The operating cash flow (OCF) for each year is derived from:

- After-tax operating savings

- Add back depreciation (a non-cash expense)

The formula:

OCF = (Savings × (1 - tax rate)) + (Depreciation × tax rate)

Calculations:

- Year 1:

- After-tax savings: $20,000 × (1 - 0.40) = $12,000

- Depreciation tax shield: $19,800 × 0.40 = $7,920

- Total OCF: $12,000 + $7,920 = $19,920

- Year 2:

- After-tax savings: $20,000 × 0.60 = $12,000

- Depreciation tax shield: $27,000 × 0.40 = $10,800

- Total OCF: $12,000 + $10,800 = $22,800

- Year 3:

- After-tax savings: $12,000

- Depreciation tax shield: $9,000 × 0.40 = $3,600

- Total OCF: $12,000 + $3,600 = $15,600

Note: Since the machine is sold at the end of Year 3, we consider depreciation recapture and salvage value separately.

Terminal Cash Flows at the End of Year 3

Upon sale, Kidd receives the salvage value of $20,000. However, the book value at the end of Year 3 also needs to be calculated for tax implications:

Book Value after 3 years:

Sum of depreciation expenses:

- Year 1: $19,800

- Year 2: $27,000

- Year 3: $9,000

- Total accumulated depreciation: $55,800

Book value at Year 3:

$60,000 – $55,800 = $4,200

Gain on Sale:

Salvage value: $20,000

Book value: $4,200

Gain: $20,000 – $4,200 = $15,800

Tax on Gain:

Gain is taxable, so tax expense:

$15,800 × 40% = $6,320

Net salvage value:

$20,000 – $6,320 = $13,680

Additional Cash Flow:

The net salvage proceeds are received at the end of Year 3, adding to terminal cash flows.

Total Terminal Cash Flow:

= Salvage value after tax + Book value recovered (if any)

= $13,680 + $4,200 (if applicable)

However, the washout of book value and tax implications usually result in recognizing the after-tax salvage value as above, so the cash inflow is $13,680.

Note: The book value recovers the residual economic value, and taxes on the salvage value are factored based on the gain.

Profitability Analysis

To evaluate whether the project is profitable at an average risk level, we compute the Net Present Value (NPV) by discounting the operating and terminal cash flows to Year 0 at the firm’s cost of capital (10%).

Using the NPV formula:

\[ NPV = \sum \frac{OCF_t}{(1 + r)^t} + \frac{Terminal\ Cash\ Flow}{(1 + r)^3} - Initial\ Investment \]

Plugging in the numbers:

- Year 1: $19,920 / (1.10)^1 = $18,109

- Year 2: $22,800 / (1.10)^2 = $18,859

- Year 3: $15,600 / (1.10)^3 = $11,718

Terminal cash flow discounted:

- $13,680 / (1.10)^3 = $10,297

Total PV of cash flows:

$18,109 + $18,859 + $11,718 + $10,297 = $59,983

NPV:

= Total PV of cash flows – Initial investment

= $59,983 – $60,000 = –$17

Since the NPV is approximately zero (negligible negative), the project is marginally acceptable, indicating it would be expected to be at least break-even and potentially profitable considering real-world uncertainties.

Conclusion

Based on the detailed analysis, the proposed investment in the labeling machine requires an initial outlay of $60,000, produces annual after-tax operating cash flows ranging from approximately $15,600 to $22,800, and generates a salvage value after tax of about $13,680 at the end of three years. The computed NPV suggests the project is marginally profitable at the company's required rate of return of 10%. Given Kidd’s goal for capital efficiency and risk considerations, the project may be considered acceptable, especially if strategic benefits or qualitative factors support the decision. However, if strict financial profitability is prioritized, further sensitivity analyses or adjustments may be warranted.

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