Question

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company is evaluating the replacement of an old machine with a new one. Last year, th cd a consultant to conduct a feasibility study about this replacement project, which cost them $1,000,000 at that time. The consulting fees were expensed last year. he old machine was purchased 2 years ago for $3 million and was being depreciated using MACRS 5-year class (20%, 32%, 19.2%, i l 52% 11 .52% and 5.76%). The old machine can be sold for S800,000 at this time. If the old machine is not replaced, it can be sold for 5300,000 four years from now. The replacement machine has a cost of $2.5 million, an estimated useful life of 4 years. This iciated using straight-line method to 0 salvage value. The replacement machine would permit an output expansion, so sales would rise by $750,000 per year; even so, the new machine's much greater efficiency would cause operating expenses to decline by $200,000 per year. The new machine would require that inventories be increased by $800,000 and accounts payable increase by $200,000 respectively. The interest expense on the debt component of the capital required for this project will be $500,000 annually. The new machine can be sold for $100,000 at the end of 4 years to another company. The company's marginal federal-plus-state tax rate is 40%, and its WACC is 12%.

1. What is the initial investment CF0 ?

2. What is the CF1 ( The Cash Flow to be used in NPV calculations)?

3. What is the CF4 ( The Cash Flow to be used in NPV calculations)?

4. What is the NPV of the project?

Answer 1

Answer 1:

Old machine:

Old Machine: Depreciation Schedule Year Depreciation rate Depreciation Accumulated depreciation $600,000 $1,560,000 $2,136,000 $2,481,600 $2,827,200 $3,000,000 Book Value 1 2 4 19.20%) 11.52%) 32.00%) 115296 20.00% 5.76% $600,000 $960,000 $576,000 $345,600 $345,600 $172,800 $2,400,000 $1,440,000 $864,000$518,400 $172,800 $0

Book Value now = $1,440,000

Sale value = $800,000

Tax on Loss = (1440000 - 800000) * 40% = $256,000

Sale value net of tax =800000 + 256000 = $1,056,000

Workings capital:

Increase in working capital = Increase in inventory - Increase in accounts payable = 800000 - 200000 = $600,000

Initial investment CF0:

Initial investment CF0 = New Machine cost - sale value of old machine net of tax + Increase in working capital

= 2500000 - 1056000 + 600000

= $2,044,000

Initial investment CF0 = $2,044,000

Answer 2 and 3:

CF1 = $589,600

CF4 = $1,230,880

Workings:

Year New Machine Sale value of old machine net of tax Increase in working capital 0 $2,500,000 $1,056,000 ($600,000 2 4 $600,000 $750,000 $750,000 $750,000$750,000 $200,000 $200,000 $200,000$200,000 $625,000) ($625,000)($625,000) ($625,000 S576,000) ($345,600)($345,60o)($172,800 $49,000) ($279,400)($279,400)(S452,200 670,600$497,800 360,400) ($268,240)($268,240)($199,120 2,360 $298,680 400$452,200 Increase in sales Decrease in operating cost Depreciation new machine Depreciation old machine Incremental depreciation Incremental savings before tax Tax on incremental savin Incremental savings after tax Add back depreciation $670,600 $901,000 $540,600$402,360 9,000 279,400 $402 $279,4 $180,000 $60,000 ($120,000) Salvage value old machine net of tax Salvage value new machine net of tax Incremental salvage value ($2,044,000)$589,600 $681,760 $1,230,880 Cash flow

Answer 4:

NPV of the project = $293,433.26

Workings:

Year New Machine Sale value of old machine net of tax Increase in working capital 0 $2,500,000 $1,056,000 ($600,000 2 4 $600,000 $750,000 $750,000 $750,000$750,000 $200,000 $200,000 $200,000$200,000 $625,000) ($625,000)($625,000) ($625,000 ($172,800) $49,000) ($279,400)($279,400)(S452,200 $901,000 $670,600 $670,600$497,800 360,400) ($268,240)($268,240)($199,120 2,360 $298,680 400$452,200 Increase in sales Decrease in operating cost Depreciation new machine Depreciation old machine Incremental depreciation Incremental savings before tax Tax on incremental savin Incremental savings after tax Add back depreciation S576,000) ($345,600)($345,60o) $540,600$402,360 9,000 279,400 $402 $279,4 $180,000 $60,000 ($120,000 Salvage value old machine net of tax Salvage value new machine net of tax Incremental salvage value Cash flow PV factor ( 1/(1+12%)/year) Discounted cash flow NPV ($2,044,000) $589,600 $681,760 $681,760 $1,230,880 0.635518 ($2,044,000.00) $526,428.57 $543,494.90 $485,263.30 $782,246.49 0.892857 0.797194 0.711780 $293,433.26

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Table added (please refer comment):

Row # | Year New Machine Sale value of old machine net of tax Increase in working capital 0 $2,500,000 $1,056,000 ($600,000 4 $600,000 4 $750,000 $750,000 $750,000$750,000 $200,000 $200,000 $200,000$200,000 $625,000) ($625,000)($625,000) ($625,000 S576,000) ($345,600)($345,60o)($172,800 $49,000) ($279,400)($279,400)(S452,200 670,600$497,800 360,400) ($268,240)($268,240)($199,120 2,360 $298,680 400$452,200 Increase in sales Decrease in operating cost Depreciation new machine Depreciation old machine Incremental depreciation (row 7- row 8 9 10 Incremental savings before tax (row 5 row 6 row 9 11 Tax on incremental saving (row 10 *-40% 12 Incremental savings after tax (row 10 -row 11) 13 Add back depreciation 14 15 Salvage value old machine net of tax 16 Salvage value new machine net of tax 17 Incremental salvage value (row 16 - row 15) $670,600 $901,000 $540,600$402,360 9,000 279,400 $402 $279,4 $180,000 $60,000 ($120,000) ($2,044,000) $589,600 $681,760 $681,760 $1,230,880 Cash flow (row 1+ row 2 + row 3 + row 12 PV factor ( 1/(1+12%)/year) Discounted cash flow NPV row 13 +row 1 0.892857 0.797194 0.711780 0.635518 ($2,044,000.00) $526.428.57 S543,494.90 $485,263.30 S782.246.49 $293,433.26