Question

Exercise 17.4

Alliance Manufacturing Company is considering the purchase of a new automated drill press to replace an older one. The machine now in operation has a book value of zero and a salvage value of zero. However, it is in good working condition with an expected life of 10 additional years. The new drill press is more efficient than the existing one and, if installed, will provide an estimated cost savings (in labor, materials, and maintenance) of $6,000 per year. The new machine costs $25,000 delivered and installed. It has an estimated useful life of 10 years and a salvage value of $1,000 at the end of this period. The firm’s cost of capital is 14 percent, and its marginal income tax rate is 40 percent. The firm uses the straight-line depreciation method.

Complete the following table to compute the net present value (NPV) of the investment. (Hint: Remember that, in Year 10, Alliances also receives the salvage value of the machine.)

Year	Cash Flow	PV Interest Factor at 14%	Present Value (PV)
	($)		($)
0		1.00000
1		0.87719
2		0.76947
3		0.67497
4		0.59208
5		0.51937
6		0.45559
7		0.39964
8		0.35056
9		0.30751
10		0.26974
		Net Present Value

Should Alliance replace its existing drill press?

Yes

No

Answer 1

Investment in new machine= 25000

i = 14%

T = 10 yrs

Annual savings = 6000

Salvage value = 1000 after 10 yrs

Tax rate = 40% = 0.4

Depreciation amount in each year = (Purchase value-salvage value)/useful life = (25000-1000)/10 = 2400

Net income for tax purpose = Annual savings - Depreciation

Tax = Tax rate * (Annual savings -Depreciation)

Net cash flow = Net income for tax purpose - Tax + Depreciation

using excel

Year	investment	Depreciation	Benefits	Salvage	Taxable income	Tax	Net Cash flow after tax	PV Factor	Present value
0	-25000						-25000	1.00000	-25,000.00
1		2400	6000		3600	1440	4560	0.87719	4,000.00
2		2400	6000		3600	1440	4560	0.76947	3,508.77
3		2400	6000		3600	1440	4560	0.67497	3,077.87
4		2400	6000		3600	1440	4560	0.59208	2,699.89
5		2400	6000		3600	1440	4560	0.51937	2,368.32
6		2400	6000		3600	1440	4560	0.45559	2,077.47
7		2400	6000		3600	1440	4560	0.39964	1,822.35
8		2400	6000		3600	1440	4560	0.35056	1,598.55
9		2400	6000		3600	1440	4560	0.30751	1,402.24
10		2400	6000	1000	4600	1840	5160	0.26974	1,391.88
									-1,052.67

Alliance Manufacturing Company should not buy new machine as its NPV is negative