In: Finance
Progress Incorporated is considering buying a new machine to increase production. It will cost $200,000 to purchase, $10,000 to modify and $5,000 to have it installed. It has a five-year class life. At the end of three years they plan to sell the machine for $95,000. The new machine will allow Progress to increase revenues by $80,000 each year but expenses will increase by $5,000 each year. Inventory will decrease by $6,000 and wages payable will increase by $2,000 if the machine is purchased. Straight-line depreciation will be used. Progress’s marginal tax rate is 34% and its cost of capital is 7%. Should PI purchase the new machine? Complete the following parts:
We can decide whether PI should purchase the machine or not based on Net present value criteria. | ||||||
If NPV of the proposal turns out positive, PI should purchase the new machine otherwise not. | ||||||
Calculation of net present value of new machine | ||||||
Year | 0 | 1 | 2 | 3 | NPV | |
Installed cost of new machine | -$215,000.00 | |||||
Decrease in net working capital | $8,000.00 | |||||
Increase in net working capital | -$8,000.00 | |||||
Operating cash flow | $64,120.00 | $64,120.00 | $64,120.00 | |||
After tax Salvage value of machine | $91,940.00 | |||||
Net Cash flow | -$207,000.00 | $64,120.00 | $64,120.00 | $148,060.00 | ||
x Discount factor @ 7% | 1 | 0.9345794 | 0.8734387 | 0.81629788 | ||
Present Values | -$207,000.00 | $59,925.23 | $56,004.89 | $120,861.06 | $29,791.19 | |
As the NPV of new machine is positive , PI should purchase the new machine. | ||||||
Working | ||||||
Calculation of operating cash flow of the new machine per year | ||||||
Increase in revenue | $80,000.00 | |||||
Less : Increase in expense | $5,000.00 | |||||
Less : Depreciation | $43,000.00 | |||||
Profit before tax | $32,000.00 | |||||
Less : Tax @ 34% | $10,880.00 | |||||
Add : Depreciation | $43,000.00 | |||||
Operating cash flow | $64,120.00 | |||||
Depreciation per year using straight line method = (Installed cost - residual value) / useful life | ||||||
Depreciation per year using straight line method = ($215000 - $0) / 5 years = $43000 | ||||||
After tax salvage value of machine at the end of 3rd year | ||||||
Sale value of machine | $95,000.00 | |||||
Less : Book value at the end of 3rd year | $86,000.00 | |||||
[$215000 - $129000] | ||||||
Profit on sale | $9,000.00 | |||||
Tax on profit @ 34% | $3,060.00 | |||||
After tax salvage value [Sale value - Tax] | $91,940.00 | |||||