Question

8, 9

(15 pts) 8. Crowder Manufacturing, Inc. is considering the replacement of an existing machine. The new machine costs $750,000 and requires installation costs of $250,000. The existing machine can be sold currently for $300,000 before taxes. It is one year old, cost $600,000 new, and has a $500,000 book value and a remaining useful life of 5 years. Depreciation expense on the existing machine is $100,000 per year. Over its 5-year life, the new machine should reduce operating costs by $300,000 per year. The new machine will be depreciated on a straight- line basis to a zero salvage value over its 5-year life. The new machine can be sold for $100,000 net of removal and cleanup costs at the end of 5 years. An increased investment in net working capital of $100,000 will be needed to support operations if the new machine is acquired. The firm has a 16% cost of capital and is subject to a 25% tax rate. Should Crowder replace the existing machine? Show computations. (16 pts) 9. Robinson Enterprises is considering whether to pursue an aggressive or conservative current asset investment policy. The firm's annual sales are $4,000,000; its fixed assets are $2,000,000; debt and equity are each 50% of total assets. EBIT is $400,000, the interest rate on the firm's debt is 10%, and the firm's tax rate is 30%. With an aggressive policy, current assets will be 20% of sales. Under a conservative policy, current assets will be 60% of sales. Show computations.

Answer 1

Question 8

purchase cost of new machine	1000000
sale value of old machine	(300000)
tax benefit (500000-300000)*0.25	(50000)
additional working capital requirement	100000
Net Outflow	750000
Annual Benefit from replacement of machine	300000
Tax Expense for the benefit	(75000)
tax benefit for additional depreciation (200000-100000)*0.25	25000
Net Inflow every year for 5 years	250000
Terminal Benefits
Sale value of Machine	100000
Tax Expense on profit of sale of machine(100000*0.25)	(25000)
Release of working capital	100000
Total Inflow	175000

Year	Amount	Present Value factor @16%	Present Value
0	(750000)	1.00	(750000)
1	250000	0.8621	215517
2	250000	0.7432	185791
3	250000	0.6407	160164
4	250000	0.5523	138073
5	425000	0.4761	202348
	Net Present Value		151893

As the net present value is positive, so we go for replacement of machine.

Question 9

	Aggresive	Conservative
Revenue	4000000	4000000
Current Assets as % of Revenue	20%	60%
Current Assets	800000	2400000
Fixed Assets	2000000	2000000
Total Assets	2800000	4400000
Equity	1400000	2200000
Debt	1400000	2200000

PARTICULARS	AGGRESSIVE	CONSERVATIVE
EBIT	400000	400000
INTEREST ON DEBT @10%	140000	220000
EBT	260000	180000
TAX @30%	78000	54000
EAT	182000	126000
EQUITY	1400000	2200000
% OF RETURN ON EQUITY	13%	5.73%

IT SHOULD BE BETTER TO FOLLOW AGGRESSIVE APPROACH.