Question

A company is evaluating the purchase of Machine A. The new machine would cost $120,000 and would be depreciated for tax purposes using the straight-line method over an estimated ten-year life to its expected salvage value of $20,000. The new machine would require an addition of $30,000 to working capital. In each year of Machine A’s life, the company would reduce its pre-tax costs by $40,000. The company has a 12% cost of capital and is in the 35% marginal tax bracket.

a. Identify the incremental cash flows from investing in Machine A.

b. Calculate the investment’s net present value (NPV).

c. Calculate the investment’s internal rate of return (IRR).

Answer 1

Cost of Machine Salvage Value Life $ 1,20,000 $ 20,000 10 years Depreciation = ($ 120,000 - $ 20,000) /10 $ 1,00,000 / 10 $ 10,000 Computation of NPV Machine A Years Particulars 0 1 2 3 4 5 6 7 8 9 10 Cash Outflows: Major Overhaul (1,20,000) Cash Inflows Saving in Post tax costs Tax Saving on Depreciation Working Capital Recovered Salvage Value 26,000 3,500 26,000 3,500 26,000 3,500 26,000 3,500 26,000 3,500 26,000 3,500 26,000 3,500 26,000 3,500 26,000 3,500 26,000 3,500 30,000 20,000 (a) Net Incremental Cash flow (1,20,000) PV factor @ 8% (b) 1.000 Present Value (axb) (1,20,000) 29,500 0.89286 26,339 29,500 0.79719 23,517 29,500 0.71178 20,998 29,500 0.63552 18,748 29,500 0.56743 16,739 29,500 0.50663 14,946 29,500 0.45235 13,344 29,500 0.40388 11,915 29,500 0.36061 10,638 79,500 0.32197 25,597 (b) Net Present Value (NPV) 62,780 Solution c) Computation of IRR Machine A Year Cash flows 0 (1,20,000) 1 29,500 2 29,500 3 29,500 4 29,500 5 29,500 6 29,500 7 29,500 8 29,500 9 29,500 10 79,500 EIRR (series) 22.61% or 23%

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