Case 2

Damon corporation, a sports equipment manufacturer, has a machine currently in use that was originally purchased 3 years ago for $120,000.
The firm depreciates the machine under MACRS using a 5-year recovery period. Once removal and cleanup costs are taken into consideration,
the expected net selling price for the present machine will be $70,000.
Damon can buy a new machine for a net price of $160,000 (including installation costs of $15,000). The proposed machine will be depreciated
under MACRS using a 5-year recovery period. If the firm acquires the new machine, its working capital needs will change : Accounts receivable
will increase $15,000, inventory will increase $19,000, and accounts payable will increase $16,000
Earnings before depreciation, interest, and taxes (EBDIT) for the present machine are expected to be $95,000 for each of the successive 5 years.
For the proposed machine, the expected EDBIT for each of the next 5 years are $105,000, $110,000, $120,000, $120,000, and $120,000,
respectively. The corporate tax rate (T) for the firm is 40%. (Table 4.2 on page 166 contains the applicable MACRS depreciation percentages.)
Damon expects to be able to liquidate the proposed machine at the end of its 5-year usable life for $24,000 (after paying removal and cleanup
costs). The present machine is expected to net $8,000 upon liquidation at the end of the same period. Damon expects to recover its net working
capital investment upon termination of the project. The firm is subject to a tax rate of 40%.
Create a spreadsheet similar to tables 11.1, 11.5, 11.7, and 11.9 to answer the following:
a. Create a spreadsheet to calculate the initial invesment
b. Create a spreadsheet to prepare a depreciation schedule for both the proposed and the present machine. Both machine are depreciated under
MACRS using a 5-year recovery period. Remember that the present machine has only 3 years of depreciation remaining.
c. Create a spreadsheet to calculate the operating cash flows for Damon Corporation for both the proposed and the present machine.
d. Create a spreadsheet to calculate the terminal cash flow associated with the project.
e. Determine the payback period of the project?
f. Determine the profitability index of the project?
g. Determine the IRR of the project?
h. Determine the NPV of the project?
i. Provide the recommendation based on your analysis on those criteria

Answer
INFORMATION DATA
Original purchase price 3 years ago $120.000
Net selling price of the existing machine $70.000
Cost of new machine (including installation costs) $160.000
Installation costs $15.000
Salvage value of new machine (after 5 years) $24.000
Salvage value of existing machine (after 5 years) $8.000
Changes to working capital:
Increase in accounts receivable $15.000
Increase in inventory $19.000
Increase in accounts payable $16.000 $18.000
$95.000

EBDIT for the present machine next 5 years

EBDIT for the proposed machine for next five years:
1 $105.000
2 $110.000
3 $120.000
4 $120.000
5 $120.000
Tax 40%
Depreciation MACRS 5-year recovery Old Machine 120,000
MACRS 5-year Table 4.2
Percentage
MACRS 5-year Table 4.2 ( New Machine) Recovery year recovery
Percentage
Recovery year recovery 1 20% $24.000
1 20% $32.000 2 32% $38.400
2 32% $51.200 3 19% $22.800
3 19% $30.400 4 12% $14.400
4 12% $19.200 5 12% $14.400
5 12% $19.200 6 5% $6.000
6 5% $8.000 7 0% $0
8 0% $0
9 0% $0
 Damon Corporation

a. Calculation of the Initial Investment

(1) Installed cost of new machine

Cost of machine $145.000
+ Installation cost $15.000
Total installed cost—proposed $160.000
(depreciable value)
− (2) After-tax proceeds from sale of old machine
Proceeds from sale of old machine $70.000
Tax on sale of old machine $14.080
Total after-tax proceeds $55.920
(3) Change in net working capital $18.000
Initial Investment $122.080
(1) − (2) + (3)

Tax on sale of old machine

Purchase price of the old machine $120.000
Accumulated depreciation
− Depreciation for year 1 $24.000
− Depreciation for year 2 $38.400
− Depreciation for year 3 $22.800
Total accumulated depreciation $85.200
 Book value of machine at end of year 3 $34.800
Selling price of old machine $70.000
Recaptured depreciation $35.200
Tax on recaptured depreciation $14.080

Change in net working capital

(1) Change in current assets

Increase in accounts receivable $15.000
Increase in inventory $19.000 $34.000

(2) Change in current liabilities

Increase in accounts payable $16.000 $16.000
Change in working capital [(1) − (2)] $18.000
b. Depreciation schedule (for the next six years)

Ownership Year Cost MACRS rate Depreciation

With proposed NEW machine 1 $160.000 20% $32.000
2 $160.000 32% $51.200
3 $160.000 19% $30.400
4 $160.000 12% $19.200
5 $160.000 12% $19.200
6 $160.000 5% $8.000
$160.000

With present (old) machine Ownership Year Cost MACRS rate Depreciation
4 $120.000 12% $14.400
5 $120.000 12% $14.400
6 $120.000 5% $6.000
7 $120.000 0% $0
8 $120.000 0% $0
9 $120.000 0% $0
$34.800

c. Calculation of Operating Cash Flow for Damon Corporation's Proposed and Present Machines
 Cash Flow Years (new) proposed
machine Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Ownership Years New Machine Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Earnings before depr. and int. and taxes $105.000 $110.000 $120.000 $120.000 $120.000 $0
−Depreciation $32.000 $51.200 $30.400 $19.200 $19.200 $8.000
EBIT Earnings before interest and taxes $73.000 $58.800 $89.600 $100.800 $100.800 ($8.000)
− Taxes $29.200 $23.520 $35.840 $40.320 $40.320 ($3.200)
Net operating profits after taxes $43.800 $35.280 $53.760 $60.480 $60.480 ($4.800)
+ Depreciation $32.000 $51.200 $30.400 $19.200 $19.200 $8.000
Operating cash flows $75.800 $86.480 $84.160 $79.680 $79.680 $3.200

Cash Flow Years - present (old)

machine Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Ownership Years Old Machine Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Earnings before depr. and int. and taxes $95.000 $95.000 $95.000 $95.000 $95.000 $0
−Depreciation $14.400 $14.400 $6.000 $0 $0 $0
Earnings before interest and taxes $80.600 $80.600 $89.000 $95.000 $95.000 $0
− Taxes $32.240 $32.240 $35.600 $38.000 $38.000 $0
Net operating profits after taxes $48.360 $48.360 $53.400 $57.000 $57.000 $0
+ Depreciation $14.400 $14.400 $6.000 $0 $0 $0
Operating cash flows $62.760 $62.760 $59.400 $57.000 $57.000 $0
 Incremental Relevant Operating Cashe Flows
Proposed Present Incremental
Cash Flow Years
machine Machine Cash flow
1 $75.800 $62.760 $13.040
2 $86.480 $62.760 $23.720
3 $84.160 $59.400 $24.760
4 $79.680 $57.000 $22.680
5 $79.680 $57.000 $22.680
6 $3.200 $0 $3.200
$110.080