# Cleveland Manufacturing wants to invest \$220,000 on a new machine

November 24, 2016

Cleveland Manufacturing wants to invest \$220,000 on a new machine to replace an old machine which still has the book value \$20,000 and salvage value \$15,000. This will enable an increase production of 10000 units per month. The machine is to be used for 3 years at the end of which it can be sold for \$90,000 in today’s (real) dollars. The machine is a 5-year recovery asset. To fund this investment, the company plans to borrow \$150,000 at 4.5% interest rate to be paid back in two years. The selling price of the product is \$20 per unit now and is expected to increase at the rate of 5%. The per-unit labor cost, overhead cost, and material cost are \$2, \$1, and \$1.50 respectively. The inflation rates for all these costs are 4%, 6% and 5% respectively. If the combined effective federal and state tax rate of the company is 45% and the current capital gains taxes rate is 15%. Construct the corresponding project cash flows by filling the missing entries in the Cash Flow Statement below. Then determine whether the expansion project proposed is economically viable, if the after-tax market interest rate is 15% and the general economy inflation rate is 4%. (Note depreciation is always in current dollars)

(For a 5-year recovery asset: the MACRS % for Year 1 through 6 are: 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%; and (A/P,4.5%,2) = 0.5340)

Cost basis for the new machine = _____________

Depreciation: Year 1 = ________

Year 2 = ________

Year 3 = ________

Total depreciation = __________

Book value = __________

Salvage value in year 3 = __________ _

Gains tax = _________ (ordinary gains, capital gains or tax credits?)

Show your work by using the following templates to help prepare quantities required for the table:

Payments for borrowed funds: Borrowed amount:= \$150000, Before-tax interest rate =______

# of years to payback = 2

Annuity payments: _____________________

Year k Beginning balance Interest payment Principal Payment Ending balance

1 150000 6750 ____________ ____________

2 __________ ___________ 76650 ____________

Then fill in the missing entries (indicated by empty cells with underscore) in the following table.

____
Year

Inflation rate

0

1

2

3

Cash Flow Statement

Operating Activities

Revenues

5%

210000

______

231525

Expenses

Labor

4%

-20800

______

______

6%

-10600

______

-11910

Materials

5%

______

-16538

______

Interest payments

______

-3449

0

Income taxes (45% rate)

-49995

______

______

Investment Activities

Capital investment

-225000

Salvage value

4%

______

Gains tax

______

Financial Activities

Borrowed funds

150000

Principal repayments

______

-76650

0

Net cash Flow

-75000

32755

______

203145

_______

PW

NOTES:

Net Operating income = Revenue-Expenses (excluding Taxes)

156100

______

179753

Depreciation

______

-72000

______

Taxable Income

______

______

______

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