Question

The John Deer Company is evaluating the replacement of one of its machines. The machine was originally purchased ten years ago at a cost of $35,000 and has been depreciated to a book value of zero. If Pioneer replaces the machine, it will be able to bid on larger projects that require the capabilities of the new machine. The new machine will cost the firm $80,000, which will be depreciated over 4 years according to the following depreciation rates: 40% in each of years 1 and 2, and 10% in each of years 3 and 4. The new machine qualifies for an immediate 2% investment tax credit. Pioneer anticipates that at the end of the machine’s eight year economic life it will be sold for $10,000. Pioneer estimates that its existing machine can be sold today for $5,000. If John Deer does not replace the machine, it anticipates being able to use the existing machine for eight more years at which time its salvage value would be zero. Without the purchase of the new machine, John Deer expects to generate revenue of $200,000 per year. The firm’s use of its existing machine is expected to generate operating expenses of $120,000 per year. If the new machine is purchased, Pioneer expects the firm’s annual revenues and operating costs to increase to $270,000 and $170,000 respectively. John Deer's marginal tax rate is 40%. To finance this project, Pioneer will raise 30% of the capital from debt and 70% of the capital from equity; its after-tax cost of debt is 8% and the cost of equity is 18%. a. Calculate the NPV for this project. b. Calculate the IRR for this project; you should use Excel to do this. Calculate the IRR to 2 decimals; for example, 25.63%.

Answer 1

Revenue	1	2	3	4	5	6	7	8
New machine	270000	270000	270000	270000	270000	270000	270000	270000
Old Machine	200000	200000	200000	200000	200000	200000	200000	200000
Inc. revenue	70000	70000	70000	70000	70000	70000	70000	70000
Expenses
New machine	170000	170000	170000	170000	170000	170000	170000	170000
Old Machine	120000	120000	120000	120000	120000	120000	120000	120000
Inc. expenses	50000	50000	50000	50000	50000	50000	50000	50000
Incremental depreciation %	40%	40%	10%	10%
Incremental depreciation	32000	32000	8000	8000
Year	0	1	2	3	4	5	6	7	8
Inc. revenue		70000	70000	70000	70000	70000	70000	70000	70000
Inc. expenses		50000	50000	50000	50000	50000	50000	50000	50000
Depreciation		32000	32000	8000	8000	0	0	0	0
EBT		-12000	-12000	12000	12000	20000	20000	20000	20000
Tax @ 40%		-4800	-4800	4800	4800	8000	8000	8000	8000
Tax credit of 2%		-1600
Total tax		-6400	-4800	4800	4800	8000	8000	8000	8000
PAT		-5600	-7200	7200	7200	12000	12000	12000	12000
Add: depreciation		32000	32000	8000	8000	0	0	0	0
Add: sale from old m/c	5000
Less: purchase of new m/c	80000
Total Cash Flow	-75000	26400	24800	15200	15200	12000	12000	12000	12000
WACC	%	Cost
Debt	30%	8%
Equity	70%	18%
WACC	15.00%
NPV @ 15%	$4,981.90
IRR	17.44%