Question

2. You have just been hired by Edifice Wrecks, Inc. (the demolition company) to evaluate a proposal to purchase a new solar-powered, web-enabled building smasher to replace an existing hand-powered smasher. You have discovered that:

• The old hand-powered smasher was purchased 5 years ago for $90,000 and is being depreciated for tax purposes using the straight-line method over an 8-year life to a $10,000 salvage value. The old smasher’s salvage value remains $10,000, however, it could be sold today for $25,000. $15,000 is invested in working capital in support of this smasher.
• The new smasher would cost $125,000 and be depreciated for tax purposes using the straight-line method over a 3-year life to a salvage value of $5,000. With the new smasher, revenues are expected to increase from $4,000,000 to $4,055,000 in each of the next 3 years. At the end of the 3 years, the new smasher could be sold for its accounting salvage value of $5,000. The new smasher would require $25,000 in supporting working capital.
• The firm is in the 35% marginal income tax bracket and has a 13% cost of capital.

1.    Prepare the cash flow spreadsheet for the analysis of this project.
2.    Calculate the project’s:

1.    net present value (NPV)
2.    internal rate of return (IRR)

3.    Should the new smasher be purchased? Why or why not?

Answer 1

a) Step 1:

Calculation of Cash Flows of New Project

Particulars	0	1	2	3
Cash Outflows
Cost of New Smasher	$(125,000.00)
Incremental Working Capital (Note 1)	$(10,000.00)
Cash inflows
Increment in revenue (Note 2)		$55,000.00	$55,000.00	$55,000.00
Less: Increase in Depreciation (Note 3)		$(30,000.00)	$(30,000.00)	$(30,000.00)
Profit before tax		$25,000.00	$25,000.00	$25,000.00
Less: Tax @35%		$8,750.00	$8,750.00	$8,750.00
Profit after tax		$16,250.00	$16,250.00	$16,250.00
Add: Depreciation		$30,000.00	$30,000.00	$30,000.00
Less: Reduction in Salvage Value				$(5,000.00)
Add: Release of Working capital				$10,000.00
Cash inflows on sale of old smasher (Note 4)	$26,750.00
Cash Flows	$(108,250.00)	$46,250.00	$46,250.00	$51,250.00
PVF @ 13%	1	0.885	0.783	0.693
Present Value	$(108,250.00)	$40,931.25	$36,213.75	$35,516.25

1. Incremental Working Capital = $25,000-$10,000 = $10,000

2. Increment in revenue = $4,055,000 - $4,000,000 =  $55,000

3. Calculation of depreciation of both Machines

Particulars	Old Smasher	New Smasher
Purchase Cost	$90,000.00	$125,000.00
Salvage	$10,000.00	$5,000.00
Depreciatiable value	$80,000.00	$120,000.00
Life	8	3
Depreciation p.a.	$10,000.00	$40,000.00

Incremental depreciation = $30,000

Reduction in salvage value = $5,000

4. Calculation of Cash Inflow of old hand-powered smasher

Value at the end of Yr 5	$30,000.00
Sale value	$25,000.00
Loss on Machinery	$5,000.00
Tax Savings on Loss	$1,750.00
Cash Flow	$26,750.00

b) Step 2:

Calculation of Net Present Value

NPV = Present Value of Cash Outflows - Present value of Cash Inflow

NPV = $112,661.25 - $108,250

NPV = $ 4,411.25

Step 3:

Calculation of IRR

IRR is the rate at which NPV = 0, NPV at Cost of Capital = 13% is positive, So we need to discount the cash flows at a higher rate.

Let, assume Cost of capital = 16%

Cash Flows	$(108,250.00)	$46,250.00	$46,250.00	$51,250.00
PVF @ 16%	1	0.862	0.743	0.641
Present Value	$(108,250.00)	$3,9867.5	$34,363.75	$32,851.25

NPV= $107,082.5 - $ 108250 = - $1167.50

NPV at Ke =13% = $ 4,411.25

NPV at Ke =16% = - $1167.50

Using Interpolation:

IRR = 13% + 3%* 4411.25(4411.25-(-1167.50))

IRR= 13% + 3%*.7907

IRR= 15.37% (Approx)

c) Step 4:

Decision : Since the NPV of the New Project is positive. We should accept the project.