Question

Big Rock Brewery currently rents a bottling machine for $55,000 per​ year, including all maintenance expenses. The company is considering purchasing a machine instead and is comparing two alternate​ options: option a is to purchase the machine it is currently renting for $155,000​, which will require $21,000 per year in ongoing maintenance​ expenses, or option​ b, which is to purchase a​ new, more advanced machine for $260,000​, which will require $19,000 per year in ongoing maintenance expenses and will lower bottling costs by $13,000 per year.​ Also, $37,000 will be spent upfront in training the new operators of the machine. Suppose the appropriate discount rate is 9% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each​ year, as is the rental of the machine. Assume also that the machines are subject to a CCA rate of 25% and there will be a negligible salvage value in 10​ years' time​ (the end of each​ machine's life). The marginal corporate tax rate is 38%. Should Big Rock Brewery continue to​ rent, purchase its current​ machine, or purchase the advanced​ machine? To make this​ decision, calculate the NPV of the FCF associated with each alternative.​ (Note: the NPV will be​ negative, and represents the PV of the costs of the machine in each​ case.)

Answer 1

PV of CCA tax shield (with salvage value = 0) is

Cost*CCA rate*Tax rate*(1 + 0.5*discount rate)/[(CCA rate + discount rate)*(1+discount rate)]

For purchasing the current machine, PV of CCA tax shield is

155,000*25%*38%*(1+0.5*9%)/[(25%+9%)*(1+9%)] = 41,520.84

For purchasing the new machine, PV of CCA tax shield is

260,000*25%*38%*(1+0.5*9%)/[(25%+9%)*(1+9%)] = 69,647.87

The PV calculations for each alternative are:

The lowest PV is for the alternative of buying the current machine so the current machine should be purchased.