Claross Inc. wants to determine the relevant operating cash flows associated with the proposed purchase of a new piece of equipment that has an installed cost of $10 million and falls into the five-year MACRS asset class.
The firm's financial analyst estimated that the relevant time horizon for analysis is six years. She expects the revenues attributable to the equipment to be $15.8 million in the first year and to increase at 5 percent per year through year 6. Similarly, she estimates all expenses, other than depreciation attributable to the equipment, to total $12.2 million in the first year and to increase by 4 percent per year through year 6. She plans to ignore any cash flows after year 6.
The firm has a marginal tax rate of 40 percent and its required return on the equipment investment is 13 percent. (Note: Round all cash flow calculations to the nearest $0.01 million.)
a. Find the relevant incremental cash flows for years 0 through 6.
b. Using the cash flows found in part (a), determine the NPV and IRR for the proposed equipment purchase.
c. Based on your findings in part (b), would you recommend that Claross Inc. purchase the equipment? Why?