Question

use paper and not excel

5) Filkins Fabric Company is considering the replacement of its old, fully depreciated knitting machine. Two models are available: Machine 190-3, which has a cost of $190,000, a 3-year expected life, and after-tax cash flows of $87,000 per year; and Machine 360-6, which has a cost of $360,000, a 6-year life, and after-tax cash flows of $98.300 per year. If the company chooses to buy the Machine 190-3, it will have to buy one machine now and a second machine in three years, the project will still last six years total. Knitting machine prices are not expected to rise. Assume that Filkins' cost of capital is 14%. Should the firm replace the old knitting machine, and, if so, which new machine should it use? a) NPV(190-3) = $20,070, NPV(360-6) = $22,256; Choose 360-6

Answer 1

Answer:

Machine (360-6) has useful life of 6 years and Machine (190-3) has useful life of 3 years. So to compare and evaluate we have to calculate cash flows of machine (190-3) assuming it is purchased second time at the end of year 3.

Machine (190-3):

Cash flows:

Year 0 Cash flow = -$190,000

Year 1 cash flow = $87000

Year 2 cash flow = $87000

Year 3 cash flow = $87000 -190000 = -$103,000

Year 4 cash flow = $87000

Year 5 cash flow = $87000

Year 6 cash flow = $87000

Hence:

NPV of machine (190-3) = -190000 + 87000 /(1+ 14%) + 87000/(1+14%)^2 - 103000 / (1 + 14%)^3 + 87000 / (1 + 14%)^4

+ 87000 / (1 + 14%)^5 + 87000 / (1 + 14%)^6

= $20,070

Machine (360-6):

Cash flows:

Year 0 Cash flow = -$360,000

Year 1 to Year 6, annual cash flow = $98,300

NPV = Annual cash flow * PV of $1 annuity for 6 years at 14% rate - Year 0 cash flow

= 98300 * (1 - 1 /(1+14%)^6)/14% - 360000

= $22,256

Hence:

NPV of machine (190-3) = $20,070

NPV of machine (360-6) = $22,256

Since NPVs are positive, the firm should replace the old machine. Further since machine (360-6) has higher NPV, the old machine should be replaced with machine (360-6)