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Jordan Chemicals is considering the purchase of a new machine for $1,000,000.
Jordan Chemicals is considering the purchase of a new machine for $1,000,000. Although the machine will not produce any increase in sales it will improve the efficiency of the company and reduce labour costs by $250,000 in the first year. However, these savings are expected to be reduced by 5% each year through the life of the machine. To operate the machine properly workers would have to go through, at the time of installation, an initial brief training session that would cost $60,000. In addition, it would cost $100,000 to install the machine. Both these expenses are tax deductible at the end of the first year. Also, because the machine is extremely efficient it will necessitate an immediate increase in inventory/ working capital of $75,000, which is expected to be returned at the end of the project's life. This machine has an expected life of five years, at which time it will have a salvage value of $70,000. Depreciation is calculated on a straight-line basis.
The company's required rate of return is 15% p.a. and the tax rate is 40%.
a) What is the depreciation each year and what are the cash flows associated with the depreciation tax saving?
b) What are the cash flows associated with disposing of the equipment at t=5?
c) What are the after tax labour cost savings for each of the years?
d) What are the after tax cash flows at t=0 and t=1? (2 marks)
e) What is the NPV of the project, and should it be undertaken?
