Finance Assignment

You have been asked by the president of the Farr Construction Company to evaluate the proposed
acquisition of a new earth mover. The mover’s basic price is $50,000, and it would cost another $10,000
to modify it for special use. Assume that the mover falls into the MACRS 3-year class (see Appendix
11A), that it would be sold after 3 years for $20,000, and that it would require an increase in net
working capital (spare parts inventory) of $2,000 at the start of the project. This working capital will be
recovered at Year 3. The earth mover would have no effect on revenues, but it is expected to save the
firm $20,000 per year in before-tax operating costs, mainly labor. The firm’s marginal federal-plus-state
tax rate is 25%.
a. What are the Year-0 cash flows?
b. What are the operating cash flows in Years 1, 2, and 3?
c. What are the additional (nonoperating) cash flows in Year 3?
d. If the project’s cost of capital is 10%, should the earth mover be purchased?
Solution:
a.
Year 1 Year 2 Year 3 Year 4
0.3333 0.4445 0.1481 0.0741
$19,998 $26,670 $8,886 $4,446

CF0 CF1 CF2 CF3

CAPEX: $- $- $-
($50,000)
($10,000) $20,000 $20,000 $20,000

($19,998) ($26,670) ($8,886)

$2 ($6,670) $11,114
NWC:
($2,000) ($0.5) $1,667.5 ($2,778.5)

$1.5 ($5,002.5) $8,335.5

$19,998 $26,670 $8,886

$16,111.5

$2000

($62,000) $19,999.5 $21,667.5 $35,333

CF0 CF1 CF2 CF3

($62,000) $19,999.5 $21,667.5 $35,333
Book Value of Machine = $4,446
Market Value = $20,000
Price = 20,000-4,446 = $15,554
After TAX = 15,554*25% = $3,888.5
Profit = $20,000-3,888.5 = $16,111.5

Calculate NPV:

CF 1 CF 2 CF 3
NPV = CF0 + 1
+ 2
+ 3
(1+i) (1+i) (1+ i)

19,999.5 21,667.5 35,333

= 62000 + 1
+ 2
+ 3
(1.1) (1.1) (1.1)

NPV = 634.59 > 1 invest