Question

Nuke-A-Bird, Inc. sells frozen chicken meals. The company needs to purchase some new freezers for storing inventory. If the freezers are purchased, they will replace old freezers purchased 10 years ago for $105,000, and these are being depreciated on a straight line basis to a zero book value (15-year depreciable life). The old freezers can be sold for $60,000 today, and $2,000 in 5 years. The new freezers will cost $200,000 installed and will be depreciated on a straight-line basis to a book value of 0. The new freezers will have a salvage value of $25,000 at the end of the 5th year. The firm expects to increase its pre-tax revenues by $50,000 per year if the new freezers are purchased, but cash expenses will also increase by $6,000 because the new freezers require greater electrical expense. If the firm's cost of capital is 10 percent and its tax rate on income and capital gains is 34%, what is the NPV of the new freezers? a) What is the after-tax SV of the new machine in 5-years? b) What is the after-tax SV of the old machine today? In 5-years? c) What is the annual difference in the FCFF from the new project? d) Should the old ones be replaced?

Answer 1

Answer (a):

Book value of new freezer at the end year 5 = 0

Salvage value = $25,000

After tax SV of new machine in 5-years = 25000 * (1 - 34%) = $16,500

After tax SV of new machine in 5-years = $16,500

Answer (b):

Purchase cost of old machine 10 years before = $105,000

Annual depreciation = (Cost - salvage value) / Useful life = 105000 / 15 = $7,000

Book value now = 105000 - 7000 * 10 = $35,000

The old freezers can be sold for $60,000 today

Gain on sale = 60000 - 35000 = 25000

Tax on gain = 25000 * 34% = $8,500

After-tax SV of the old machine today = 60000 - 8500 = $51,500

After-tax SV of the old machine today = $51,500

Answer (c):

Depreciation of new machine = 200000 / 5 = $40,000

Annual difference in the FCFF = (Increase in revenue - Increase in cost) * (1 - Tax rate) + Incremental depreciation * Tax rate

= (50000 - 6000) * (1 - 34%) + (40000 - 7000) * 34%

= $40,260

Annual difference in the FCFF = $40,260

Annual FCFF from Year 0 to Year 5 are calculated and given below:

NPV is also calculated:

The above excel with 'show formula' is given below:

Answer (d)

Yes

The old machine should be replaced with new machine.

NPV is calculated (answer c above) = $13,542.66

The replacement project should be accepted as NPV is positive.