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Marian runs a store selling decorative breathing masks. For obvious reasons, she has recently seen a...

Marian runs a store selling decorative breathing masks. For obvious reasons, she has recently seen a sharp uptick in business and wants to increase her production capacity. To accomplish this, she wants to buy a new industrial sewing machine, which will allow her to increase her yearly EBIT by $15,000 per year for the next 4 years. The sewing machine costs $36,000, but if she makes this purchase, she will borrow $28,000 for 4 years at 6.5% to help pay the purchase price. Her tax rate is 36%, and her cost of levered equity is 15%.

2A. What is the NPV of buying the new sewing machine if Marian pays cash?

2B. Using the FTE method, what is the NPV of buying the new sewing machine if Marian takes out the loan?

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Expert Solution

Marian runs a store selling decorative breathing masks. For obvious reasons, she has recently seen a sharp uptick in business and wants to increase her production capacity. To accomplish this, she wants to buy a new industrial sewing machine, which will allow her to increase her yearly EBIT by $15,000 per year for the next 4 years. The sewing machine costs $36,000, but if she makes this purchase, she will borrow $28,000 for 4 years at 6.5% to help pay the purchase price. Her tax rate is 36%, and her cost of levered equity is 15%.

2A. What is the NPV of buying the new sewing machine if Marian pays cash?

2B. Using the FTE method, what is the NPV of buying the new sewing machine if Marian takes out the loan?

Answer 2A -

The NPV of the new sewing machine, if Marian pays cash will be computed as below:

Period Cash Flow Tax @ 36% Net CFAT Factor used Factor PV
Initial Investment ($36,000) $0 ($36,000) 1.00 ($36,000)
Years 1-4 $15,000 $5,400 $9,600 PVAF (15%,4 yrs) 2.855 $27,408
Net Present Value ($8,592)

Thus, purchasing the machine has a negative NPV, if brought outright with cash.

Note : Since no information has been provided regarding the depreciation of the machine, or its possible salvage value after 4 years, these and their available tax shield has been ignored.

Answer 2B -

The NPV of the new sewing machine, if Marian pays takes out the loan will be computed as below:

Particulars Amount
EBIT per year $15,000
Less: Interest ($28,000*6.5%) ($1,820)
Earnings before taxes $13,180
Less: Taxes @ 36% ($4,745)
Earnings after taxes (CFAT) $8,435
PVAF (15%, 4 years) 2.855
PV of CFAT (Gross flow to equity) $24,082
Less: Initial Investment ($36,000)
NPV (Net flow to equity) ($11,918)

Thus, purchasing the machine has a negative NPV, as per the FTE method, even if a loan is used for purchasing it.

jeff jeffy answered 1 year ago
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