Question

Beryl's Iced Tea currently rents a bottling machine for

$ 53 comma 000$53,000

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

$ 150 comma 000$150,000.

This machine will require

$ 24 comma 000$24,000

per year in ongoing maintenance expenses.

b. Purchase a​ new, more advanced machine for

$ 265 comma 000$265,000.

This machine will require

$ 15 comma 000$15,000

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

$ 13 comma 000$13,000

per year.​ Also,

$ 36 comma 000$36,000

will be spent upfront training the new operators of the machine.

Suppose the appropriate discount rate is

7 %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 corporate tax rate is

20 %20%.

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

PVF@7% = 1/(1+7%)^n	1.0000	0.9346	0.8734	0.8163	0.7629	0.7130	0.6663	0.6227	0.5820	0.5439	0.5083
Particulars / Year	0	1	2	3	4	5	6	7	8	9	10
Renting Bottling Machine
Operating Expenses (A)	-	-53,000	-53,000	-53,000	-53,000	-53,000	-53,000	-53,000	-53,000	-53,000	-53,000
Tax Saved @ 20% (B)	-	10,600	10,600	10,600	10,600	10,600	10,600	10,600	10,600	10,600	10,600
Free Cash Flow A + B	-	-42,400	-42,400	-42,400	-42,400	-42,400	-42,400	-42,400	-42,400	-42,400	-42,400
Discounted Cash Flow	-	-39,626	-37,034	-34,611	-32,347	-30,231	-28,253	-26,405	-24,677	-23,063	-21,554
NPV (Sum of the Discounted Cash Flows)	-297,800
Option A Purchasing machine
Operating Expenses (A)	-	-24,000	-24,000	-24,000	-24,000	-24,000	-24,000	-24,000	-24,000	-24,000	-24,000
Depreciation (B)	-	-21,429	-21,429	-21,429	-21,429	-21,429	-21,429	-21,429	-	-	-
Tax Saved @ 20% (C) = (A-B) x 20%	-	9,086	9,086	9,086	9,086	9,086	9,086	9,086	4,800	4,800	4,800
Expenses after Tax (D) = (A+B+C)	-	-36,343	-36,343	-36,343	-36,343	-36,343	-36,343	-36,343	-19,200	-19,200	-19,200
Purchase of Machine (E)	-150,000	-	-	-	-	-	-	-	-	-	-
Free Cash Flow (F) = (D-B-E)	-150,000	-14,914	-14,914	-14,914	-14,914	-14,914	-14,914	-14,914	-19,200	-19,200	-19,200
Discounted Cash Flow (F) x PVF@7%	-150,000	-13,939	-13,027	-12,174	-11,378	-10,634	-9,938	-9,288	-11,175	-10,444	-9,760
NPV (Sum of the Discounted Cash Flows)	-261,756
Option B Purchasing advanced machine
Operating Expenses (A)	-	-15,000	-15,000	-15,000	-15,000	-15,000	-15,000	-15,000	-15,000	-15,000	-15,000
Savings in bottling costs (B)	-	13,000	13,000	13,000	13,000	13,000	13,000	13,000	13,000	13,000	13,000
Training Costs (C)	-36,000	-	-	-	-	-	-	-	-	-	-
Depreciation (D)	-	-37,857	-37,857	-37,857	-37,857	-37,857	-37,857	-37,857	-	-	-
Tax Saved @ 20% (C) = (A-B-C-D) x 20%	7,200	7,971	10,571	10,571	10,571	10,571	10,571	10,571	3,000	3,000	3,000
Expenses after Tax (E) = (A+B+C)	-28,800	-31,886	-29,286	-29,286	-29,286	-29,286	-29,286	-29,286	1,000	1,000	1,000
Purchase of Machine (E)	-265,000	-	-	-	-	-	-	-	-	-	-
Free Cash Flow (F) = (D-B-E)	-293,800	5,971	8,571	8,571	8,571	8,571	8,571	8,571	1,000	1,000	1,000
Discounted Cash Flow (F) x PVF@7%	-293,800	5,581	7,487	6,997	6,539	6,111	5,712	5,338	582	544	508
NPV (Sum of the Discounted Cash Flows)	-248,402

Since the negative NPV is lower in Option B, the company can go for option B