Question

Apple is considering a replacement machine that has a cost of $25,000.  The new machine will permit output expansion, so annual revenues are estimated at $5,000 during its operating period.  The new machine's greater efficiency is expected to reduce operating expenses by $3,000 per year.  This machine has an estimated useful life of 5 years and will be depreciated using a straight-line basis.  The machine will cause a change in working capital of $3,000 per year. California's marginal tax rate is 40% and its cost of capital is 5%.  Use the following equation in your effort to answer the following questions.

CFt = EBITt(1-TAXt) + DEPt -    WCRt - CAPEXt

1. Create a cash flow schedule and determine if Apple should replace the old machine?
2. Briefly discuss in words only how your analysis process might change in the following situations:
3. The increase in sales is highly dependent on the strength of the economy.
4. The replacement machine is much more reliable than the existing one so that the risk of temporary shut downs in production is lower.
5. The replacement machine has an estimated useful life of seven years

Answer 1

	a. Initial Investment
	Cost:
	Equipment Cost			$               25,000
	Working Capital reduction		$                -3,000
	TOTAL			$               22,000
	b. Present Value of Annual Cashflows
	Reduction in operating expenses	$                 3,000
	Less: Tax @30%			$                     900
	After Tax Operating Income	$                 2,100
	Add: Depreciation		$                 5,000
	Cash after tax operating income	$                 7,100
	Number of years			5
	Discounting Rate			5%
	Annuity Factor of 13% for 5 Years	4.33
	Present Value of Annual Inflow	=$7100*4.33
				$               30,739
	c. Terminal Cash flows
	Working Capital adjustment	$                 3,000
	PV factor			0.78
	PV of working capital		$                 2,351
	d. Net Present Value(NPV)
NPV	= Initial Investment + Present value of Annual CashFlows + Terminal Cash flows
	= $-22000+30739-2351
NPV	$                    6,389
	Since the NPV is positive, the new machine shall be purchased.
	Analysis of other points:
1	The increase in sales is highly dependent on the strength of the economy.
	Sales would not affect the decision of buying the new machine as the same is equally applicable for both the option of whether to buy new machine or not.
2	The replacement machine is much more reliable than the existing one so that the risk of temporary shut downs in production is lower.
	This would make the option of replacement better.
3	The replacement machine has an estimated useful life of seven years.
	This would make the option of replacement better.