Question

Silver Bakers, Inc. (SBI) has an opportunity to invest in a new bread-making machine. SBI needs more productive capacity, so the new machine will not replace an existing machine. The new machine is priced at $250,000 and will require modifications costing $13,000. It has an expected useful life of 10 years, will be depreciated using the MACRS method over its 5-year class life, and has an expected salvage value of $12,500 at the end of Year 10. (See Table 10A.2 for MACRS recovery allowance percentages.) The machine will require a $23,000 investment in net working capital. It is expected to generate additional sales revenues of $125,000 per year, but its use also will increase annual cash operating expenses by $55,000. SBI’s required rate of return is 10 percent, and its marginal tax rate is 40 percent. The machine’s book value at the end of Year 10 will be $0, so SBI will have to pay taxes on the $12,500 salvage value.

a. What is the NPV of this expansion project? Should SBI purchase the new machine?

b. Suppose SBI’s required rate of return is 12 percent rather than 10 percent. Should the new machine be purchased in this case?

c. Should SBI purchase the new machine if it is expected to be used for only five years and then sold for $31,250? (Note that the model is set up to handle a five-year life; you need enter only the new life and salvage value.)

d. Would the machine be profitable if revenues increased by only $105,000 per year? Assume everything else is as originally presented and evaluated in part a.

e. Suppose that revenues rose by $125,000 but expenses rose by $65,000. Would the machine be acceptable under these conditions? Assume a 10-year project life and a salvage value of $12,500.

Answer 1

a]

The cash flows and NPV of the project are calculated as below :

Net cash flow in year 0 = initial investment in equipment + increase in working capital

Net cash flow in year s 1 to 9 = Income after taxes + depreciation

Net cash flow in year 10 = Income after taxes + recovery of working capital + net cash from sale of equipment

Net cash from sale of equipment = $12,500 * (1 - 40%)

To calculate the NPV, the net cash flow for each year is discounted back to the present using 10% discount rate. The sum of the PV of net cash flows for each year is the NPV of the project

As the NPV is positive, SBI should purchase the machine

b]

The NPV is calculated using 12% discount rate

With 12% discount rate, the NPV is still positive. SBI should purchase the machine

c]

Book value of machine at end of year 5 = $263,000 - $52,600 - $84,160 - $50,496 - $30,298   = $45,446

loss on sale of machine = $45,446 - $31,250 = $14,196

net cash from sale of machine = $31,250 + ($14,196 * 40%) = $36,929

As the NPV is negative, SBI should not purchase the machine

d]

The NPV is negative. The machine is not profitable

e]

the NPV is positive. The machine would be acceptable