Question

Beryl's Iced Tea currently rents a bottling machine for $ 54,000 per​ year, including all maintenance expenses. It is considering purchasing a machine​ instead, and is comparing two​ options:

A. Purchase the machine it is currently renting for $ 160,000. This machine will require $ 21,000 per year in ongoing maintenance expenses.

B. Purchase a​ new, more advanced machine for $ 260,000. This machine will require $ 15,000 per year in ongoing maintenance expenses and will lower bottling costs by $ 11,000 per year.​ Also, $ 39,000 will be spent upfront training the new operators of the machine. Suppose the appropriate discount rate is 7% 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 will be depreciated via the​ straight-line method over seven years and that they have a​ ten-year life with a negligible salvage value. The marginal corporate tax rate is 38%. Should​ Beryl's Iced Tea 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

Solution:
Calculation of NPV under each option:
Option1: Renting of Machine
Particulars	Years	Free Cash Flows (FCF)	PVF @ 7%	Present Value
Rent	1-10	54,000	7.0236	379,274.40
Less: Tax @ 38%	1-10	20,520	7.0236	144,124.27
Present Value of Cash Outflows				235,150.13
Option 2: Purchase Current Machine
Particulars	Years	Free Cash Flows (FCF)	PVF @ 7%	Present Value
Purchase Amount	0	160,000	1	160,000.00
Maintenance Expenses (1)	1-10	13,020	7.0236	91,447.27
Tax Saving on Depreciation (2)	1-7	(8,686)	5.3893	(46,809.90)
Present Value of Cash Outflows				204,637.38
(1) Maintenance Expenses = 21000 (1-tax rate)
21000 (1-0.38)= $13020
(2) Depreciation 160000/7= $22857.14
Tax Saving on Depreciation = 22,857.14*38%= $8685.71
Option 3: Purchase Advanced Machine
Particulars	Years	Free Cash Flows (FCF)	PVF @ 7%	Present Value
Purchase Amount	0	260,000	1	260,000.00
Operator Training Expenses (Net of Tax) (39000- (1-0.38))	0	24,180	1	24,180.00
Bottling Cost (Net of Tax) ( 11000(1-0.38))	1-10	(6,820)	7.0236	(47,900.95)
Maintenance Expenses (3)	1-10	9,300	7.0236	65,319.48
Tax Saving on Depreciation (4)	1-7	(14,114)	5.3893	(76,066.14)
Present Value of Cash Outflows				225,532.38
(3) Maintenance Expenses = 15000 (1-tax rate)
15000 (1-0.38)= $9300
(4) Depreciation 260000/7= $37,142.86
Tax Saving on Depreciation = 37,142.86*38%= $14,114.29
Decision : Purchase Current Machine as there is lower present value of cash outflows