Question

Hashem Oghli is a manufacturer of plastic products. Unfortunately, one of the moulding machines is out of order and needs to be replaced.

After receiving quotes from various suppliers, you find two types of moulding machines that are suitable. Type A moulding machine is a high-end machine; it has a higher purchase price but makes higher quality products that sell better on the market and bring more revenue. Type B moulding machine is lower-end; it is cheaper, but produces lower quality products and higher scraps that require rework. In addition, this machine produces less environmental pollution, therefore due to governmental program, this machine is tax exempt.

Hashem Oghli's managment asks you to evaluate these machines and recommend the best one. Cost structures of the two types are given below:

Type A machine:

Purchase price = $100,000

Salvage value = $20,000

Yearly revenue = $60,000

Yearly maintenance cost = $15,000

Yearly cost of scrap = $5,000

Type B machine:

Purchase price = $15,000

Salvage value = $0

Yearly revenue = $40,000

Yearly maintenance cost = $15,000

Yearly cost of scrap = $15,000

It is expected that both machines depreciate fast and will have to be replaced after three years (the company uses straight line depreciation method).

The company is using a discount rate of 6%. The tax rate for machine A is 10% and for machine B is 0%. (Note that neither choice would impact working capital.)

Below, you can find the incremental income statement for buying machine Type A. However, you can derive the incremental statement for Type B machine by replacing the relevant values. Note that the operating expense includes cost of maintenance and scrap production.

Annual Income Statement Item	Y1	Y2	Y3
Revenue	$ 60	$ 60	$ 60
Operating Expenses:
Maintenance	$ (15)	$ (15)	$ (15)
Scrap Production	$ (5)	$ (5)	$ (5)
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)	$ 40	$ 40	$ 40
Depreciation	?	?	?
Earnings Before Interest and Taxes (EBIT)	?	?	?
Taxes	?	?	?
Net Operating Income After Tax	?	?	?

Note: all values are in thousand dollars. Use one decimal point precision in your calculations and answers.

Your task is to analyze the financial performance of the two options over three years and compare them. Answer the following questions.

A) What is the Net Present Value (NPV) for Type A machine?

B) What is the Net Present Value (NPV) for Type B machine?

Answer 1

A). NPV of Type A machine = 20,251.6

Formula	Annual Income Statement Item	Y1	Y2	Y3
	Year (n)	1	2	3
	Revenue ('R)	60,000	60,000	60,000
	Operating Expenses (OE):
	Maintenance	(15,000)	(15,000)	(15,000)
	Scrap Production	(5,000)	(5,000)	(5,000)
R-OE	Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)	40,000	40,000	40,000
Straight line over 3 years: Purchase price/3	Depreciation (D)	(33,333)	(33,333)	(33,333)
EBITDA - D	Earnings Before Interest and Taxes (EBIT)	6,667	6,667	6,667
10%*EBIT	Taxes	(667)	(667)	(667)
EBIT - Tax	Net Operating Income After Tax (NI)	6,000	6,000	6,000
	NPV calculation:
	Add: depreciation (D)	33,333	33,333	33,333
NI + D	Operating Cash Flow (OCF)	39,333	39,333	39,333
salvage value*(1-Tax rate)	After-tax salvage value (SV)			18,000
OCF + ASV	Free Cash Flow (FCF)	39,333	39,333	57,333
1/(1+d)^n	Discount factor @ 6%	0.943	0.890	0.840
FCF*Discount factor	PV of FCF	37,106.9	35,006.5	48,138.2
Sum of all PVs -purchase price	NPV	20,251.6

B). NPV of Type B machine = 11,730.1

Formula	Annual Income Statement Item	Y1	Y2	Y3
	Year (n)	1	2	3
	Revenue ('R)	40,000	40,000	40,000
	Operating Expenses (OE):
	Maintenance	(15,000)	(15,000)	(15,000)
	Scrap Production	(15,000)	(15,000)	(15,000)
R-OE	Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)	10,000	10,000	10,000
Straight line over 3 years: Purchase price/3	Depreciation (D)	(5,000)	(5,000)	(5,000)
EBITDA - D	Earnings Before Interest and Taxes (EBIT)	5,000	5,000	5,000
0 Tax rate	Taxes	-	-	-
EBIT - Tax	Net Operating Income After Tax (NI)	5,000	5,000	5,000
	NPV calculation:
	Add: depreciation (D)	5,000	5,000	5,000
NI + D	Operating Cash Flow (OCF)	10,000	10,000	10,000
	After-tax salvage value (SV)			-
OCF + ASV	Free Cash Flow (FCF)	10,000	10,000	10,000
1/(1+d)^n	Discount factor @ 6%	0.943	0.890	0.840
FCF*Discount factor	PV of FCF	9,434.0	8,900.0	8,396.2
Sum of all PVs -purchase price	NPV	11,730.1