Question

A certain firm is evaluating the proposed acquisition of a new milling machine. The cost
of machine is Rs. 1,000,000 and it would cost another Rs. 200,000 to modify it for
special use. The firm has been using the straight-line depreciation assuming 5 years life
and Rs 100,000 of salvage value. The machine would require an increase in net working
capital (inventory) of Rs.100,000. The milling machine would have no effect on
revenues, but it is expected to save the firm Rs. 400,000 per year in before-tax operating
costs, mainly in labor. Company’s marginal tax rate is 40 percent. If the project’s cost of
capital is 12 percent, should the machine be purchased? Give your decision based on
NPV and IRR.

Answer 1

Cost of Machine	$       1,000,000
Add : Modification cost	$          200,000
Total Capitalized cost	$       1,200,000
Salvage value	$          100,000
Depreciable value	$       1,100,000
Useful life in years	5
Annual depreciation=$1.1M/5 =	$      220,000.0
Incremental NWC required	100,000
Tax rate =	40%
Annual Depreciation Tax savings =220000*40%=	88,000
Annual Operating cost savings before tax	400,000
After Tax Annual Labor cost saving=400,000*(1-40%)=	240,000
Cost of Capital=	12%

	Let Us find the NPV of Replacement
	Details	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	Initial Capital Investment	(1,200,000)
	Invenstment in NWC=	(100,000)
a	Total Initial Investment	(1,300,000)
	Cash flow from Operations
	After Tax Operating cost savings		240,000	240,000	240,000	240,000	240,000
	Add: Depreciation Tax savings		88,000	88,000	88,000	88,000	88,000
b	Total Cash flow from Operations		328,000	328,000	328,000	328,000	328,000
	Terminal Cash flow
	Salvage Value						100,000
	Return of NWC						100,000
c	Total Terminal Cash flow						200,000
d	Total Free Cash flow from Project=a+b+c	(1,300,000)	328,000	328,000	328,000	328,000	528,000
e	PV factor @12%=1/1.12^n=	1	0.8929	0.7972	0.7118	0.6355	0.5674
f	PV of FCF =d*e=	(1,300,000)	292,871	261,482	233,470	208,444	299,587
g	NPV =Sum of PV of cash flows=	(4,146)

So NPV =	$       (4,145.60)
IRR (using excel formula)	11.88%

As NPV of replacement is negative and IRR is also below the cost of Capital, the new milling machine should not be purchased.