Question

Two years ago, a company purchased a machine. Currently, the machine can be sold for Rs. 2500 having a book value of Rs. 2100. The remaining life of the machine is 6 years and is depreciated using a straight-line depreciation method. Therefore, it records Rs. 350 per year as an annual depreciation expense. The company may sell the machine for Rs. 500 after it completes its useful life if it is not replaced with a new one which is technologically more advanced. A representative of high-tech manufacturing machines approaches the company and offers to replace its old machine with a new one for Rs. 8000. This new machine would be having Rs. 800 as an estimated scrap value at the end of its expected useful life of 6 years. The applicable depreciation rates according to 5-years MACRS class life are 20 percent, 32 percent, 19 percent, 12 percent, 11 percent and 6 percent, respectively. This new machine would help the company increase its revenues by 1000 annually and decrees its operating expenses by 1500 annually. However, the company would be needed to increase its inventories by Rs. 2000 as well as the accounts payables by Rs. 500. The composite WACC and marginal tax rate of the company are 11 percent and 40 percent, respectively. Being the financial consultant hired by the company, you are required to calculate net present value (NPV) and internal rate of return (IRR) and suggest whether the company should replace its old machine or not?

Answer 1

Net present value: $ 1,908.32

Yes, the old machine should be replaced, as the NPV of the replacement is positive.

After tax salvage value of old machine = $ 2,500 - $ ( 2,500 - 2,100) * 0.40 = $ 2,340

Increase in net working capital = - $ 2,000 + $ 500 = - $ 1,500

Net initial investment required = - $ 8,000 - $ 1,500 + $ 2,340 = - $ 7,160

Incremental EBITDA = $ 1,000 + $ 1,500 = $ 2,500

Computation of incremental depreciation:

	1	2	3	4	5	6
Depreciation of new machine	$ 1,600	$ 2,560	$ 1,520	$ 960	$ 880	$ 480
Depreciation of old machine	350	350	350	350	350	350
Incremental Depreciation	$ 1,250	$ 2,210	$ 1,170	$ 610	$ 530	$ 130

Computation of Annual Operating Cash Flows after Taxes:

Incremental annual operating cash flows after taxes = EBITDA x ( 1 - t ) + Depreciation x t

	1	2	3	4	5	6
Incremental EBITDA	$ 2,500	$ 2,500	$ 2,500	$ 2,500	$ 2,500	$ 2,500
Incremental depreciation	1,250	2,210	1,170	610	530	130
Operating cash flows	$ 2,000	$ 2,384	$ 1,968	$ 1,744	$ 1,712	$ 1,552

Computation of NPV:

	0	1	2	3	4	5	6
Net initial investment	$(7,160)
Operating cash flows		$ 2,000	$ 2,384	$ 1,968	$ 1,744	$ 1,712	1,552
Working capital recovered							1,500
Incremental after tax salvage value							180
Total cash flows	$ (7,160)	$ 2,000	$ 2,384	$ 1,968	$ 1,744	$ 1,712	$ 3,232
PV factor at 11 %	1.0000	0.9009	0.8116	0.7312	0.6587	0.5935	0.5346
Present values	(7,160)	1,801.80	1,934.85	1,439.00	1,148.77	1,016.07	1,727.83
Net Present Value	$ 1,908.32