Question

Integrativelong dashInvestment decision Holliday Manufacturing is considering the replacement of an existing machine. The new machine costs $ 1.20 million and requires installation costs of $ 150 comma 000. The existing machine can be sold currently for $ 185 comma 000 before taxes. It is 2 years old, cost $ 800 comma 000 new, and has a $ 384 comma 000 book value and a remaining useful life of 5 years. It was being depreciated under MACRS using a 5-year recovery period and therefore has the final 4 years of depreciation remaining. If it is held for 5 more years, the machine's market value at the end of year 5 will be $ 0. Over its 5-year life, the new machine should reduce operating costs by $ 350 comma 000 per year. The new machine will be depreciated under MACRS using a 5-year recovery period. The new machine can be sold for $ 200 comma 000 net of removal and cleanup costs at the end of 5 years. An increased investment in net working capital of $ 25 comma 000 will be needed to support operations if the new machine is acquired. Assume that the firm has adequate operating income against which to deduct any loss experienced on the sale of the existing machine. The firm has a 9.0 % cost of capital and is subject to a 40 % tax rate. a. Develop the relevant cash flows needed to analyze the proposed replacement. b. Determine the net present value (NPV) of the proposal. c. Determine the internal rate of return (IRR) of the proposal. d. Make a recommendation to accept or reject the replacement proposal, and justify your answer. e. What is the highest cost of capital that the firm could have and still accept the proposal?

Answer 1

(a)	(i)
	Initial cashflow -
	Cost of new machine =				-1200000
	Installation cost =				-150000
	Post tax salvage value of old machine
		Salvage value =		185000
		Book Value =		384000
		Loss =		-199000
		Tax savings on loss		-79600
	Post tax salvage value of old machine		(salvage value - tax)		264600
	Increase in NWC				-25000
	Initial cashflow -				-1110400
	(ii)	Operating cashflows =
	Year		1	2	3	4	5
	Depreciation rate on old		32	19.2	11.52	11.52	5.76
	Depreciation rate on new		20	32	19.2	11.52	11.52
	Savings in operating cost		350000	350000	350000	350000	350000
Add:	Depreciation on old	800000 x Rate	256000	153600	92160	92160	46080
Less:	Depreciation on new	1200000 x Rate	240000	384000	230400	138240	138240
	Incremental savings		366000	119600	211760	303920	257840
Less:	Tax @ 40%		146400	47840	84704	121568	103136
	Post tax Savings		219600	71760	127056	182352	154704
Less:	Depreciation on old		256000	153600	92160	92160	46080
Add:	Depreciation on new		240000	384000	230400	138240	138240
	OCF		203600	302160	265296	228432	246864
	(iii)	Terminal cashflows -
	Salvage value of New machine				20000
	Book Value =	Cost - Depreciation till now			69120
	Loss On sale				-49120
	Tax savings on loss				-19648
	Post tax salvage value =				39648
	Recovery of NWC -				25000
	Terminal cashflows				64648
(b)	NPV =
	Year	Initial cashflow	Operating cashflow	Terminal cashflow	Net cash flow	PV factor @ 9%	PV of cashflow
	0	-1110400			-1110400	1	-1110400
	1		203600		203600	0.917431	186789
	2		302160		302160	0.84168	254322
	3		265296		265296	0.772183	204857.2
	4		228432		228432	0.708425	161827
	5		246864	64648	311512	0.649931	202461.4
					NPV =		-100143
(c )	IRR =	(using IRR Function in Excel)			5.59%
	(Right a comment if you have any problem regarding this I will solve using other process)
(d)	Project should not be accepted i.e. we should continue using old machine as -
	NPV is < 0
	IRR < Discount Rate
(e)	At IRR => Cost of capital the project will be acceptable
	Highest cost of capital ==			5.59%