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

$23,000

per year in ongoing maintenance​ expenses, or option​ b, which is to purchase a​ new, more advanced machine for

$265,000​,

which will require

$19,000

per year in ongoing maintenance expenses and will lower bottling costs by

$15,000

per year.​ Also,

$39,000

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

30%

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.)

The NPV​ (rent the​ machine) is

​$?

​(Round to the nearest​ dollar.)The NPV​ (purchase the current​ machine) is

​$?.

​(Round to the nearest​ dollar.)The NPV​ (purchase the advanced​ machine) is

​$?

​(Round to the nearest​ dollar.)

Which of the following is the best​ choice?  

A.

Purchase the advanced machine.

B.

Rent the current machine.

C.

Purchase the current machine.

Answer 1

The NPV calculations are, as follows:

PV of CCA tax shield with zero salvage value is calculated as:

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*30%*38%*(1+0.5*9%)/[(30%+9%)*(1+9%)] = 43,437.19

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

265,000*30%*38%*(1+0.5*9%)/[(30%+9%)*(1+9%)] = 74,263.59

NPV of rent option = -218,842

NPV of purchasing the current machine = -203,079

NPV of purchasing the new, advanced machine = -230,832

As per the NPVs of the alternatives, purchasing the current machine is the best choice as it has the lowest cost.