The Munsell Colour Company is considering the purchase of a new batch polymer-bonding machine for producing its number one line of crayons.Although the machine being considered will not produce any increase in sales revenues,it will result in the before-tax reduction of labour costs by $200,000 per year.The machine has a purchase price of $250,000,and it would cost an additional $10,000 to install the machine.In addition,to operate this machine,inventory must be increased by $15,000.Operating expenses are expected to grow at 2.5%.The machine is categorized as 10-year property.After 2 years,it can be sold for $150,000.The tax rate is 34% and the cost of capital is 15%.What is the IRR for the proposed acquisition?
MACRS Depreciation Rates

Question

Quizplus · Accepted Answer

Step 1 - Compute the initial cash flow.
Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working Capital)
Initial cash flows = -250,000 - 10,000 - 15,000 = -$275,000
Step 2 - Compute the operating cash flow.
EBIT = Revenues - Expenses - Depr
Revenues = $0
Expenses = -$200,000
Depr = 0.10 × 260,000 = $26,000
EBIT = - (-200,000) - 26,000 = $174,000
NOPAT = EBIT × (1 - T)
NOPAT = 174,000 × (1 - 0.34) = $114,840
OCF = NOPAT + Depreciation
OCF = 114,840 + 26,000 = $140,840
 11ea7fdb_fc84_ac85_a768_57198c45cdd1_TB2902_00 Step 3 - Compute the terminal year cash flow.
 11ea7fdb_fc84_ac86_a768_1723404932a1_TB2902_00 Terminal Cash Flows = OCF + (Decrease in net working capital) + (Net salvage)
EBIT = Revenues - Expenses - Depr
Revenues = $0
Expenses = -$200,000
Depr = 0.18 × 260,000 = $46,800
EBIT = - (-200,000) - 46,800 = $158,200
NOPAT = EBIT × (1 - T)
NOPAT = 158,200 × (1 - 0.34) = $104,412
OCF = NOPAT + Depreciation
OCF = 104,412 + 46,800 = $151,212
Net Salvage = Salvage - Tax on Sale
Net Salvage = Salvage - T × (Salvage - Book Value)
Net Salvage = $150,000 - ($150,000 - $187,200) × 0.34 = $162,648
Terminal year CF = $151,212 + $15,000 + $162,648 = $328,860
Step 4 - Set the NPV = 0, solve for the IRR
0 = -$275,000 + $140,840/(1+k) + $328,860/ 11ea7fdb_fc84_d397_a768_6788552f2edb_TB2902_00 k = 37.9%

The Munsell Colour Company Is Considering the Purchase of a New