Question

Premium Pie Company needs to purchase a new baking oven to replace an older oven that requires too much energy to run. The industrial size oven will cost $1,200,000. The oven will be depreciated on a straight-line basis over its six-year useful life. The old oven cost the company $800,000 just four years ago. The old oven is being depreciated on a straight-line basis over its expected ten-year useful life. (That is, the old oven is expected to last six more years if it is not replaced now.) Due to changes in fuel costs, the old oven may only be sold today for $100,000. The new oven will allow the company to expand, increasing sales by $300,000 per year. Expenses will also decrease by $50,000 per year due to the more energy efficient design of the new oven. Premium Pie Company is in the 40% marginal tax bracket and has a required rate of return of 10%. 5a. Calculate the net present value and internal rate of return of replacing the existing machine. Ans: xxxx 5b. Explain the impact on NPV of the following: i. Required rate of return increases ii. Operating costs of new machine are increased iii. Existing machine sold for less

Answer 1

Please refer the attached document for the answer.

Notes for 5a.

1. Net Investment in Year 0 will be $1100000 ($1200000-$100000) i.e. Cost for new Oven - Sale Proceeds of old Oven

2. Additional Inflows every year will be increase in Sales + Decrease in Expenses i.e. $300000+$50000 = $350000

3. Depreciation for Old Oven is $80000 (800000/10) and Depreciation for New Oven is $200000 (1200000/6). Therefore, in case of replacement, additional depreciation of $120000 ($200000-$80000) can be claimed every year. This gives a tax benefit of $48000 every year.

4. To calculate IRR, we have used interpolation formula and 2 Rate of Returns i.e. 10% & 11%.

Notes for 5b.

i. If the Required rate of return increases, the NPV will be negative (Please refer the NPV workings @ 11% attached for 5a)

ii. In case the operating costs of the new machine are increased, the Profit available will be less and it will ultimately lead to less cash inflows which will again bring down the NPV since PV @10% is as low as $23657.26

iii. if the existing machine is sold for less than 1 lac, it will increase the Cash outflow which will reduce the NPV.