Background: The M. Milken Toupee and Lawn Service (MMTLS) is considering purchasing a new paving machine, the Beta. This new machine will replace the current paving machine, the Alpha. The Alpha was purchased two years ago for $2 million and is being depreciated on a straight-line basis, over its original economic life of 5 years, to a book value of $0. It is anticipated that the Alpha can be sold at the end of its economic life, in 3 years, for $50,000. The Alpha could be sold today for $1 million.
The Beta will cost $3 million and will be depreciated over its economic life of 3 years to a book value of $0. MTPS expects to sell the Beta in three years for $200,000. If the Beta is purchased and installed, operating costs will fall by $1 million each year for the next three years. As a result of the purchase of the Beta, accounts receivable and inventories will increase by a total of $200,000 each and accounts payable will increase by a total of $400,000. In order to properly operate the Beta, three employee need to be specially trained. When the Alpha was purchased MTPS paid $80,000 to train 3 employees and this training will also allow them to operate the Beta.
Assume that MTPS has an ordinary tax rate of 40%, a capital gain rate of 20%, and a WACC 15%. Due to current market conditions, MTPS intends to finance the Beta with 9% coupon, 3-year bonds that will be issued at par.
A) Should MTPS acquire the Beta?
To address this, find out:
The cash flows in year 0, the net initial investment (NINV).
The operating cash flows (OCF) in years 1 - 3.
The terminal-year cash flows, i.e., the non-OCF in year 3.
B) Identify which cash flows would be affected if MTPS employed an accelerated depreciated method instead of straight-line depreciation and provide the direction of the affect, i.e., positive or negative.