Airstat is replacing an old stamping line that cost $80,000 five years ago, with a new, more efficient machine that will cost $225,000. Shipping and installation will cost an additional $20,000. The old machine has a book value of $15,000 but will be sold as scrap for $5,000. The new machine will be depreciated with a 7-year life under MACRS guidelines. With the increased production, inventories will increase $4,000, accounts receivable will increase $16,000, and accounts payable will increase $14,000. If Airstat has a marginal tax rate of 40 percent, what is the net investment?

Question

Quizplus · Accepted Answer

To calculate the net investment, we need to calculate the initial outflow (IO) and the after-tax cash flows (ATCF) over the life of the project.

IO = cost of new machine + shipping and installation - scrap value of old machine
IO = $225,000 + $20,000 - $5,000
IO = $240,000

Now let's calculate the annual depreciation expense for the new machine:

Year 1: 14.29% x $225,000 = $32,203
Year 2: 24.49% x $225,000 = $55,129
Year 3: 17.49% x $225,000 = $39,131
Year 4: 12.49% x $225,000 = $28,114
Year 5: 8.93% x $225,000 = $20,097
Year 6: 8.92% x $225,000 = $20,085
Year 7: 8.93% x $225,000 = $20,097
Total depreciation = $215,856

Now we can calculate the ATCFs:

Year 0: -$240,000
Year 1: $60,000 ($80,000 increase in production - $32,203 depreciation)
Year 2: $110,000 ($80,000 increase in production + $30,000 increase in inventories - $55,129 depreciation)
Year 3: $86,131 ($80,000 increase in production + $16,000 increase in accounts receivable - $39,131 depreciation)
Year 4: $72,114 ($80,000 increase in production - $14,000 increase in accounts payable - $28,114 depreciation)
Year 5: $64,097 ($80,000 increase in production + $4,000 increase in inventories - $20,097 depreciation)
Year 6: $64,085 ($80,000 increase in production - $16,000 increase in accounts receivable - $20,085 depreciation)
Year 7: $64,097 ($80,000 increase in production - $14,000 increase in accounts payable - $20,097 depreciation)

The sum of the ATCFs is $511,524.

The net investment is IO + ATCFs - tax on sale of old machine:
Net investment = $240,000 + $511,524 - ($10,000 x 0.4)
Net investment = $242,000

Therefore, the best choice is B.

Airstat Is Replacing an Old Stamping Line That Cost $80,000