Question

Premium Pie Company needs to purchase a new baking oven to replace an older oven that requires too much energy to run. The industrial size oven will cost $1,200,000. The oven will be depreciated on a straight-line basis over its six-year useful life. The old oven cost the company $800,000 just four years ago. The old oven is being depreciated on a straight-line basis over its expected ten-year useful life. (That is, the old oven is expected to last six more years if it is not replaced now.) Due to changes in fuel costs, the old oven may only be sold today for $100,000. The new oven will allow the company to expand, increasing sales by $300,000 per year. Expenses will also decrease by $50,000 per year due to the more energy efficient design of the new oven. Premium Pie Company is in the 40% marginal tax bracket and has a required rate of return of 10%.

a. Calculate the net present value and internal rate of return of replacing the existing machine

b. Explain the impact on NPV of the following: i) Required rate of return increases ii) Operating costs of new machine are increased iii) Existing machine sold for less

Answer 1

Benefits/ loss due to purchase of new machines
	Particulars			Cash flow	PVIFA/ PVIF	Present value of cash flow
	Investment yo made at initial yr			-$12,00,000.00	Today itself	-$12,00,000.00
	Tax benefit due to increase in depreciation cost
	Depn on new m/c	200000		$48,000.00	PVIFA (10%, 6 yrs)	$2,09,052.51
	Depn on old m/c	80000
	Increase in depn	120000
	Tax benefit @40%	48000
	Sale of old machine			$1,00,000.00	Today itself	$1,00,000.00
	Tax benefit due to loss on sale of old asset			$1,52,000.00	PVIF (10%, 1)	$1,38,181.82
	(Will realized at end of 1st yr)
	Value as on date	480000
	Less: Value realized	100000
	Loss	380000
	Tax benefit @40%
	Increase in Operating profits			$2,10,000.00	PVIFA (10%, 6 yrs)	$9,14,604.75
	Sales	300000
	Exp reduced	50000
	Total	350000
	Less tax exp	140000
	Net income	210000
	NPV					$1,61,839.08
	IRR will be that rate at which NPV will be Zero
	Hence by interpolation IRR comes near to 15.30%
b)
(i)	When ROI incresaes , NPV decreases
	NPV becomes Zero when ROI tunrs out to be 15.30%
	Hence sensitivity of ROI is 53%
(ii)	When operating cost of new machines increases, NPV tends to decrease.
	Benefits resulting from Operating cost reduction in given scenario is 30,000 (50000-40% tax)
	Hence PV of operating cost reduction is 130,657
	Hence sensitivity of operating cost is 80.73%
(iii)	Existing Machine sold for less
	Benefit resulting from sale of machine now is (100000+Tax benefit of 138181)
	Hence sensitivity is 147 %