Question

7. Premium Pie Company needs to purchase a new baking oven to replace an older oven that requires too much energy to run. The industrial size oven will cost $1,200,000. The oven will be fully depreciated on a straight-line basis over its six-year useful life. The old oven cost the company $800,000 just four years ago. The old oven is being depreciated on a straight-line basis over its expected ten-year useful life. (That is, the old oven is expected to last six more years if it is not replaced now.) Due to changes in fuel costs, the old oven may only be sold today for $100,000. The new oven will allow the company to expand, increasing sales by $300,000 per year. Expenses will also decrease by $50,000 per year due to the more energy efficient design of the new oven. Premium Pie Company is in the 40% marginal tax bracket and has a required rate of return of 10%. a. Calculate the net present value and internal rate of return of replacing the existing machine. b. Explain the impact on NPV of the following: i. Required rate of return increases ii. Operating costs of new machine are increased iii. Existing machine sold for less

Answer 1

Solution:

Lets do this step wise:

a] Book value of Old Machine:

Old machine bought at 800,000 having 10 years of life will be depreciated by 80,000 per year.

b] New Owen Depreciation per year

Using SLM method

c] Incremental investment required for new machine:

Remember, Old machine is sold at 100000. It has a book value of  4,80,000. It generates a loss of  3,80,000. This will create a tax shiled of 152,000 (40% * 3,80,000)

d] Incrememtal cash flows due to new machine:

e] NPV using WACC of 10%

f] If the required rate of return increases the NPV will reduce.

g] If the operating cost of new machine increases, the cash flows will reduce and hence NPV and IRR will reduce

h] If the existing machine is sold for less the NPV will reduce.

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