Question

A manufacturer considering two alternative machine replacements. Machine 1 costs $1 million with an expected life of 5-years and will generate after-tax cash flows of $350,000 a year.

At the end of 5 years, the salvage value on Machine 1 is zero, but the company will be able to purchase another Machine 1 for a cost of $1.2 million.

The replacement Machine 1 will generate after-tax cash flows of $375,000 a year for another 5 years. At that time its salvage value will be zero.

The manufacturer's second option is to buy Machine 2 at a cost of $1.5 million today. Machine 2 will produce after-tax cash flows of $400,000 a year for 10 years, and after 10 years it will have after-tax salvage value of $100,000.

cost of capital for both machines is 12 percent.

1. What is the NPV for both machine 1 and for machine 2?
2. Which machine will have the highest NPV for the firm?
3. Please explain how the selection of the machine with the highest NPV will increase the value of the firm.
4. If the manufacturer chooses the machine that adds the most value to the firm, by how much will the company's value increase?

Answer 1

1:

	Machine 1	Machine 2
NPV	347802.00	792286.54

2: Machine 2 has the higher NPV.

3: This increases the Net value of the firm since NPV is the difference between present value of cash inflows and outflows.

4: The company's value will increase by $792286.54

Workings: Cash flows as below

Year	Machine 1	Machine 2
0	-1000000	-1500000
1	350000	400000
2	350000	400000
3	350000	400000
4	350000	400000
5	-850000	400000
6	375000	400000
7	375000	400000
8	375000	400000
9	375000	400000
10	375000	500000