Question

A firm believes it can generate an additional $4,000,000 per year in revenues for the next 10 years if it replaces existing equipment that is no longer usable with new equipment that costs $6,500,000. The existing equipment has a book value of $50,000 and a market value of $20,000. The firm expects to be able to sell the new equipment when it is finished using it (after 10 years) for $100,000. Variable costs are expected to be 54% of revenue annually. The additional sales will require an initial investment in net working capital of $400,000, which is expected to be recovered at the end of the project (after 10 years). Assume the firm uses straight-line depreciation, its marginal tax rate is 25%, and the discount rate for the project is 14%.

a) How much value will this new equipment create for the firm?

b) At what discount rate will this project break even?

c) Should the firm purchase the new equipment? Be sure to justify your recommendation.

d) How would your analysis change if the firm believes the project is more risky than initially expected? Be specific.

Answer 1

The firm should purchase the new equipment since it creates value for the firm and has a positive net present value.

This equipment will cre dow (Additional) generated by new equipment = a) Value that this equipment ! is calculated as follows: Cashi Ilow (Additional) generated by Revenue $ 4000000 (-) Variable costs $2160500 (54.1.) 1-) Depreciation $640000 (650D EOD - 18000D / 10 yeaus) Profit before $ 1200000 6) Tax @ 25.1. $ 300.000 Profit after $900000 + Depueciation. $640680 (added because it is non caste item) Cash Flow $1540000 (p.a. for 10 years) Tay 7500 * Tax benefit due to loss on sale of existing equipment -($50000 - $ 20 ) 25.7. - $7800. pe Net Puesent Value : Yeau Cash Flow. DF@ 14.1. Present Value 1-10 154000D 5.2161 8032794 - 0.8772 6579 20000 20000 500500.** 0.2697 134850 Present value of cash inflow. 3194223. (-) Investment :- Equipment (6500 DDD) Working Capital (HOO BOD) Net Present Value $ 194,223. * $ 20.000 will be received on Sale of existing equipment. ** The firm will recover $400,000 net working capital and $100000 on sale of new equipment after 10 years.