Question

Dolphin Plastics is considering replacing molding equipment used to make party cups. The current equipment was purchased two years ago for $95,000. At the time of purchase, it had a 7-year life with an expected salvage value of $10,000. If sold today Dolphin expects to receive $55,000 for the machine. Dolphin depreciates all assets using straight-line depreciation. Dolphin currently has revenue of $700,000 that is expected to grow at 5% per year. Dolphin currently has a gross profit margin of 17%.

New machinery today will cost $145,000. The new machinery is expected to last 5 years and has a salvage value of $15,000. The new machinery will lower annual operating costs by $5,000 per annum. In addition, the new machine is expected to increase expected revenue (shown below) and increase the firm’s gross profit margin to 19%. Year 1 120,000 Year 2 130,000 Yr. 4 125,000 Year 3 140,000 Yr. 5 125,000

Assume a tax rate of 25% and a cost of capital of 11%.

What is the project’s NPV?

Answer 1

Computation of NPV for old machine

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Expected revenue	700,000	735,000	771,750	810,338	850,854	3,867,942
Gross Margin (Expected revenue*17%)	119,000	124,950	131,198	137,757	144,645	657,550
Depreciation	(12,143)	(12,143)	(12,143)	(12,143)	(12,143)	(60,714)
Cash inflows before tax	106,857	112,807	119,055	125,615	132,502	596,836
Tax @ 25%	(26,714)	(28,202)	(29,764)	(31,404)	(33,126)	(149,209)
Cash inflows after tax (A)	80,143	84,605	89,291	94,211	99,377	447,627
Add : Depreciation (B)	12,143	12,143	12,143	12,143	12,143	60,714
Net cash inflows (A)+(B)	92,286	96,748	101,434	106,354	111,520	508,341
PVF @ 11%	0.901	0.812	0.731	0.659	0.593
Present value of cash inflows	83,140	78,523	74,168	70,059	66,181	372,071

Straight line depreciation
Depreciable amount (Original cost - Salvage value)	85,000
Year	Rate	Depreciation
Year 1	14.29%	12,143
Year 2	14.29%	12,143
Year 3	14.29%	12,143
Year 4	14.29%	12,143
Year 5	14.29%	12,143
Year 6	14.29%	12,143
Year 7	14.29%	12,143
Total depreciation charged	85,000
Book value at end of Year 2 (Original cost- Depreciation for 2 years)	70,714

Net present value = Present value of cash inflows - Investment in old machinery

= 372,071 - 70,714

= $301,357

Computation of NPV for new machine

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Expected revenue	700,000	735,000	771,750	810,338	850,854	3,867,942
Increase in revenue	120,000	130,000	125,000	140,000	125,000	640,000
Annual cost savings	5,000	5,000	5,000	5,000	5,000	25,000
Total revenue	825,000	870,000	901,750	955,338	980,854	4,532,942
Gross Margin (Total revenue*19%)	156,750	165,300	171,333	181,514	186,362	861,259
Depreciation	(26,000)	(26,000)	(26,000)	(26,000)	(26,000)	(130,000)
Cash inflows before tax	130,750	139,300	145,333	155,514	160,362	731,259
Tax @ 25%	(32,688)	(34,825)	(36,333)	(38,879)	(40,091)	(182,815)
Cash inflows after tax (A)	98,063	104,475	108,999	116,636	120,272	548,444
Add : Depreciation (B)	26,000	26,000	26,000	26,000	26,000	130,000
Net cash inflows (A)+(B)	124,063	130,475	134,999	142,636	146,272	678,444
PVF @ 11%	0.901	0.812	0.731	0.659	0.593
Present value of cash inflows	111,768	105,896	98,710	93,958	86,805	497,138

Straight line depreciation
Depreciable amount (Original cost - Salvage value)	130,000
Year	Rate	Depreciation
Year 1	20%	26,000
Year 2	20%	26,000
Year 3	20%	26,000
Year 4	20%	26,000
Year 5	20%	26,000
Total depreciation charged	130,000

Net present value = Present value of cash inflows - Investment in old machinery

= 497,138 - 145,000

= $352,138

Since NPV of new machine is higher than NPV of old machine, hence new machine should be installed.