Question

The management of Devine Instrument Company is considering the purchase of a new drilling machine, model RoboDril 1010K. According to the specifications and testing results, RoboDril will substantially increase productivity over AccuDril X10, the machine Devine is currently using.

The AccuDril was acquired 8 years ago for $80,000 and is being depreciated using the straight-line method over a 10-year expected life and an estimated salvage value of $20,000. The engineering department expects the AccuDril to keep going for another 3 years after a major overhaul at the end of its expected useful life. The estimated cost for the overhaul is $100,000. The overhauled machine will be depreciated using straight-line depreciation with no salvage value. The overhaul will improve the machine’s operating efficiency approximately 10% for each of years 3, 4, and 5. No other operating conditions will be affected by the overhaul.

RoboDril 1010K is selling for $240,000. Installing, testing, rearranging, and training will cost another $20,000. The manufacturer is willing to take the AccuDril as a trade-in for $30,000. The RoboDril will be depreciated using the straight-line method with no salvage value. New technology most likely will make RoboDril obsolete to the firm in 5 years.

Variable operating cost for either machine is the same: $11 per machine hour (cash-based). Other pertinent data follow:

	AccuDril X10				RoboDril 1010K
Units of output (per year)		10,000				10,000
Machine hours		8,000				4,000
Selling price per unit	$	100			$	100
Variable manufacturing cost—cash-based	$	20			$	20
(not including machine hours)
Other annual expenses (tooling and supervising)	$	70,000			$	40,000
Disposal value—today	$	25,000
Disposal value—in 5 years	$	0			$	50,000

Devine Instrument Company’s weighted-average cost of capital (WACC) is 8%, and it is in the 40% tax bracket. Use the PV factors (Appendix C, Table 1) for calculating the NPV of each decision alternative.

Required:

1. Determine for each of years 0 though 5 (inclusive) the after-tax cash flows for items that differ between the two alternatives.

2. Compute the payback period (in years) for purchasing RoboDril 1010K rather than having AccuDril X10 overhauled in 2 years. Assume for this calculation only that all cash flows (other than those related to the net acquisition cost of the replacement asset)—including tax effects—occur evenly throughout the year.

3. Using results generated in requirement 1, what is the present value of each decision alternative, keep vs. replace?

Answer 1

Case 1: Overhauling of AccuDril

Notes:

1) Revenue is calculated as = Number of products manufactured * Unit Price for sale = #100,000 * $100 = $10,000,000

2) Variable Manufacturing Cost = Number of products manufactured * Variable manufacturing cost per unit of production = #100,000 * $20 = $2,000,000

3) Variable Operating Cost for machine hours =  Number of Machine Hours * Variable Operating cost per unit of production = #8,000 * $11 = $88,000 for AccuDril and $44,000 (= #4,000 * $11) for RoboDril.

4) Depreciation of $80,000 over 10 years with a salvage value of $20,000 results in $6,000 per year.

5) Tax was considered at 40% of Net Cashflows. For year 1: 40% of $636,000 will be $ 254,400 and so forth as shown below.

6) Overhaul of the machine AccuDril was done in the Year 10 (end of the year) or 2 years from today with a cost of $100,000. For RoboDril the investment cost including installing, testing, rearranging, and training was $260,000. But the Trade-in price of $30,000 would result in a net outgo of $230,000.

7) Payback period for RoboDril was derived by dividing the outlay of $230,000 by first year cashflow (as the first year cashflow were greater than the outlay) results in 0.5737 years or 7 months approximately.

8) NPV is calculated using the formula:

NPV = Initial Investment + (Cash flows)/( 1+r)^t

Cash flows= Cash flows in the time period

r = Discount rate

t = time period

Conclusion: Since NPV of Overhailing AccuDril is higher than RoboDril, it is suggested to opt for overhauling AccuDril instead.

	AccuDril			RoboDril
	Year 8 / zero	Year 9 / 1	Year 10 / 2	Year 11 / 3	Year 12 / 4	Year 13 / 5		Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Revenue	1000000	1000000	1000000	1100000	1100000	1100000		0	1000000	1000000	1000000	1000000	1000000
variable manufacturing cost	200000	200000	200000	200000	200000	200000		0	200000	200000	200000	200000	200000
variable operating cost	88000	88000	88000	88000	88000	88000		0	44000	44000	44000	44000	44000
Gross Profits	712000	712000	712000	812000	812000	812000		0	756000	756000	756000	756000	756000
other annual expenses	70000	70000	70000	70000	70000	70000		0	40000	40000	40000	40000	40000
Depreciation	6000	6000	6000	33333.33333	33333.33333	33333.33333		0	48000	48000	48000	48000	48000
Operating Profits	636000	636000	636000	708666.6667	708666.6667	708666.6667		0	668000	668000	668000	668000	668000
Overhaul Cost / Investment	0	0	100000	0	0	0		230000	0	0	0	0	0
Net Cashflows	636000	636000	536000	708666.6667	708666.6667	708666.6667		-230000	668000	668000	668000	668000	668000
Tax	254400	254400	214400	283466.6667	283466.6667	283466.6667		0	267200	267200	267200	267200	267200
After Tax Cashflows	381600	381600	321600	425200	425200	425200		-230000	400800	400800	400800	400800	400800
Payback Period									-0.573852295
	₹ 15,68,509.64							₹ 16,00,278.18
NPV	₹ 19,50,109.64							₹ 13,70,278.18