Question

Solve not in Excel and provide all the formulas.

The company is evaluating if the replacement of an old machine is economically feasible. You have the following information:

New machine: purchase price is $8 million, economic life 10 years, annual EBITDA is $4.4 million, book value in 5 years is 0, while market value is 0.8 million. Old machine: book value today is $4 million while market value $2.8 million, remaining economic life is 10 years, annual EBITDA is $2.5 million, book value and market value in 5 years is 0. Company tax rate is 40% on both profits and capital gains. The cost of capital for the company is 14%. Find the incremental cash flows from replacement decision and evaluate if replacement is economically feasible based on NPV.

Answer 1

ANSWER-

(1) OLD MACHINE-

Capital Investment = 0

Revenue = $2.5 million

Operating Cost = 14% of $2.8 million = $392000

Depreciation = ($4 million/10) = $400000

Periodic net cash flows = (Revenue - Operating Cost - Depreciation)*(1 - tax rate) + Depreciation = ($2500000 - $392000 - $400000)*(1-40%) + $400000 = $1424800

(2) REPLACED MACHINE-

Cost of New Machine = $8 million

Sale proceeds of Old Machine = 0

Book Value of Old Asset = $4 million

Tax on sale of New Machine = 0 (since there is no sales proceeds of an old machine)

Net Initial Investment = $8 million

New Revenue = $4.4 million

New Operating Cost = 14% of $0.8 million = $112000

Depreciation = ($8 million/ 10) = $800000

Periodic Net Cash Flow = (Revenue - Operating Cost - Depreciation)*(1 - tax rate) + Depreciation = ($4.4 million - $112000 - $800000)*(1-40%) + $800000 = $2892800

(3) INCREMENTAL CASH FLOWS-

Incremental Cash Flow at time 0 = $4.4 million

Incremental Cash Flows from year 1 to 10 = (Net Annual Cash Flows after replacement - Net Annual Cash Flows before replacement)= $2892800 - $1424800 = $1468000

(4) NPV and IRR-

NPV = $1468000*PV factor for 10 yrs at 14% - $1468000 = -$1016578

IRR = 31%

Albeit the net present value is negative but IRR is higher than required rate of return of a company, old machine replacement by new machine is preferable due to high IRR.