Question

Company is replacing existing equipment with new equipment which can replicate what the existing machine does and also support a new product line.

Old equipment was purchased 3 years ago for 100,000 and was being depreciated using a MACRS 5 year asset class depreciation schedule. It was expected to have a 15,000 salvage value at the end of year 5 when it was planned to be sold. The company is considering replacing it now with a new machine. The old machine can be sold today for 35,000.

New machine will cost 180,000 and is expected to have an economic life of 8 years but is expected to use the MACRS 5 year asset class depreciation schedule for tax purposes. It is expected to have a salvage value of 12% of the original equipment costs at the end of 8 years. The remaining operational years beyond the depreciation tax schedule will not have any depreciation expense but will continue to have operational impact.

The new machine will require an increase in working capital of 10,000 in the first year of the project and will be fully recovered at the end of the project.

The new equipment is expected to increase revenue by 40,000 per year and reduce costs by 5,000 per year before tax impact and consideration of depreciation impact of the new machine.

Cost of Capital is 10% and Tax Rate is 40%.

A: Base Case scenario

• Calculate the project’s NPV
• What is your recommendation?

B: Alternate Analysis Scenarios

• What if revenue impact was only 50% of projections for the first 4 years what would be the impact on NPV?
• What if cost reduction assumptions were not realized and no operational costs savings were achieved? What would the impact on NPV be?

Answer 1

A: Calculation of incremental NPV of new machinery against old machinery
				0	1	2	3	4	5	6	7	8
Cost of an asset purchased				180000
Net proceeds from asset sold				-32520
working requirement				10000
revenue increased					40000	40000	40000	40000	40000	40000	40000	40000
cost saved					5000	5000	5000	5000	5000	5000	5000	5000
tax calculation					3600	-5040	4176	9705.6	9705.6	13852.8	18000	18000
working capital recevied]												10000
Net salvage of asset received												12960
total					41400	50040	40824	35294.4	35294.4	31147.2	27000	49960
NPV factor (10%)					0.909091	0.826446	0.751315	0.683013	0.620921	0.564474	0.513158	0.466507
PV of revenue					37636.36	41355.37	30671.68	24106.55	21915.05	17581.78	13855.27	23306.71	210428.8
PV of cost				157480									157480
											NPV		52948.77
NPV is positive, so purchase the new machinery.

B:

What if scenario
Scenario 1	Revenue increment only 50% for the first 4 years

The net effect on NPV = NPV reduced by 38038

PV of revenue					26727.27	31438.02	21655.9	15910.39	21915.05	17581.78	13855.27	23306.71	172390.4
PV of cost				157480									157480
											NPV		14910.38
NPV is positive, so purchase the new machinery.

What if scenario
Scenario 2	Cost reduction not realized

Net effect on NPV = NPV reduced by 16004

PV of revenue					34909.09	38876.03	28417.73	22057.51	20052.28	15888.36	12315.79	21907.19	194424
PV of cost				157480									157480
											NPV		36943.99
NPV is positive, so purchase the new machinery.