1. Maddux, Inc. is planning to purchase equipment worth $400,000. Delivery and setup costs will amount to $20,000. In addition, $25,000 in net working capital will be required at installation. The equipment will have a 5 year class life and will be depreciated using simplified straight line. Maddux has a marginal tax rate of 21% and a cost of capital of 12 percent.

The new equipment will increase the firm’s revenues by $220,000 per year, decrease defects costs by $10,000 per year, and increase operating costs by $30,000 per year.

a. Suppose Maddux keeps the equipment for 3 years and sells it for $200,000. What are the project’s IRR and NPV?

Step 1: Initial Outlay

New equipment cost	-400,000
Shipping & Installation	+ 20,000
Depreciable cost	= $420,000
Investment in NWC (not depreciable)	+ 25,000
Net initial outlay	= $445,000

Book value is 84,000 (420,000/5 = 84,000)

84,000 x 2 = 168, 000

Step 2: Incremental cash flows:

Increased revenue	220,000
Increased operating costs	- 30,000
Decreased defects	+10,000
Increased depreciation	- 84,000
EBT	= 116,000
Taxes (21%)	- 24,360
EAT	= 91,640
Depreciation reversal	+ 84,000
Annual cash flows	= 175,640

Step 3: Terminal Cash Flow:

		Which is a cash flow
Book Value	168,000	No
Capital gain/loss	200,000 - 168,000 = 32,000	No
Tax refund	32,000 x 21% = - 6,720	Yes, coming back (because it is capital loss carried back 3 years or carried forward up to 5 years)
Recapture of NWC	+ 25,000
Terminal cash flow	218,280

200,000 Salvage value

-6720 tax on capital gain

+ 25,000 recapture of NWC

218,280 terminal cash flow

NPV and IRR:

CFj (0) = - 445,000

CFj (1-2) = 175,640

CFj (3) = 218,280 (terminal cash flow) + 175,640 (annual cash flow for year 3) = 393,920

Discount rate = 12%
IRR = 26.25%

NPV = $132,225.04 accept the project

b. Suppose Maddux can only get $100,000 for the equipment after 3 years due to the rapidly changing technology. What are the project’s IRR and NPV?

		Which is a cash flow
Book Value	168,000	No
Capital gain/loss	100,000 - 168,000 = -68,000	No
Tax refund	68,000 x 21% = + 14,280	Yes, coming back (because it is capital loss carried back 3 years or carried forward up to 5 years)
Recapture of NWC	+ 25,000
Terminal cash flow	139,280

100,000 Salvage value

+ 14,280 tax on capital gain

+ 25,000 recapture of NWC

= 139,280 terminal cash flow

Answer rating: 100% (QA)

Step 1 Calculate Net Initial outlay Net Initial outlay Equipment cost Shipping and Instalment I... View the full answer