Question

Tough Steel, Inc. is a processor of carbon, aluminum, and stainless steel products. The firm is considering replacing an old stainless steel tube-making machine for a more cost-effective machine that can meet the firm’s quality standards. The old machine was acquired 2 years ago at an installed cost of $500,000. It has been depreciated under the MACRS’s 5-year recovery period, and has a remaining economic life of 5 years. It can be sold today for $350,000 before taxes, but if the firm decides to keep it, it can be sold for $100,000 before taxes at the end of year 5. The first option is Machine A, which can be purchased for $600,000, but will require $30,000 in installation costs. This machine would be depreciated under the MACRS’s 3-year recovery period. At the end of its economic life, the machine will have a salvage value of $350,000 before taxes. This machine would require an investment in net working capital of $100,000. The second option is Machine B, which can be purchased for $550,000, but requires $20,000 in installation costs. This machine would be depreciated under the MACRS’s 5-year recovery period. At the end of its economic life, the machine would have a salvage value of $330,000 before taxes. This machine requires no investment in net working capital. The firm has estimated the following EBIT for all three machines: The firm’s WACC is 14% and its tax rate is 40%. Determine which machine is more profitable for the company based on the payback period, discounted payback period, net present value, profitability index, internal rate of return, and modified internal rate of return. EBIT: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Old Machine $90,000 $90,000 $120,000 $150,000 $150,000 Machine A $90,000 $10,000 $150,000 $230,000 $270,000 Machine B $120,000 $20,000 $120,000 $200,000 $200,000

Answer 1

Tough Steel, Inc.
Replacement Analysis
	Old Machine	Machine A	Machine B
Price	$5,00,000	$6,00,000	$5,50,000
Installation Costs	$0	$30,000	$20,000
Original Life	7 years	5 years	5 years
Current Life	5 years	5 years	5 years
Salvage Value @ end of economic life	$1,00,000	$3,50,000	$3,30,000
Current Salvage Value	$3,50,000
Net Working Capital Investment	$0	$1,00,000	$0
MACRS's recovery period	5 years	3 years	5 years
Tax Rate	40.00%
Required Return	14.00%

EBIT:
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Old Machine		$90,000	$90,000	$1,20,000	$1,50,000	$1,50,000
Machine A		$90,000	$10,000	$1,50,000	$2,30,000	$2,70,000
Machine B		$1,20,000	$20,000	$1,20,000	$2,00,000	$2,00,000
MACRS Calculations
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Old Machine		$96,000	$57,600	$57,600	$28,800	$0
Machine A		$2,10,000	$2,80,000	$93,333	$46,667	$0
Machine B		$1,14,000	$1,82,400	$1,09,440	$65,664	$65,664
Operating Cash Flows
Old Machine		$1,50,000	$1,11,600	$1,29,600	$1,18,800	$90,000
Machine A		$2,64,000	$2,86,000	$1,83,333	$1,84,667	$1,62,000
Machine B		$1,86,000	$1,94,400	$1,81,440	$1,85,664	$1,85,664
Incremental Cash Flows
Machine A		$1,14,000	$1,74,400	$53,733	$65,867	$72,000
Machine B		$36,000	$82,800	$51,840	$66,864	$95,664
Initial Outlay & Terminal Cash Flow
Machine A	($4,35,520)					$2,50,000
Machine B	($2,75,520)					$1,51,133
ATCF
Machine A	($4,35,520)	$1,14,000	$1,74,400	$53,733	$65,867	$3,22,000
Machine B	($2,75,520)	$36,000	$82,800	$51,840	$66,864	$2,46,797

	Machine A	Machine B	Best Choice?
Payback Period	4.09	4.15	Machine A
Discounted Payback	4.75	4.82	Machine A
Net Present Value (NPV)	41,178.67	22,528.76	Machine A
Profitability Index (PI)	1.09	1.08	Machine A
Internal Rate of Return (IRR)	17.43%	16.56%	Machine A
MIRR	16.08%	15.81%	Machine A