Question

Please answer both a and b.

a. PepsiCo is considering purchasing a new machine for $200,000, which will cost $10,000 to modify for special use by the firm. The company spent $50,000 dollars traveling to different distributors analyzing various pieces of equipment. The selected equipment falls into the MACRS 3-year class (33%, 45%, 15%, 7%), and could be sold after 4 years for $40,000. Use of the equipment will require an increase of $15,000 in net working capital, which the company expects to fully recover at the end of the project’s life. The equipment is expected to increase before-tax revenues by $200,000 per year, but annual costs will amount to $50,000. The firm's marginal federal-plus-state tax rate is 40% and its WACC is 10%. Based on NPV, should PepsiCo purchase the new machine?

b. Coca-Cola Company is considering purchasing a new machine for one of its bottling facilities. The current machine has four years, $4,000 per year, of depreciation left and a market value of $50,000. The replacement machine is more efficient and is estimated to generate before-tax revenues of $50,000 per year, but with annual costs totaling $10,000. The new machine will cost $120,000 delivered and installed. The machine will be depreciated for five years to a zero salvage value using straight line depreciation. The firm’s WACC is 10%, and its marginal tax rate is 40%. Based on NPV, should the company replace its old machine?

Answer 1

NPV is the present value of cash-flows during the life of a project. The cash flow is calculated by deducting outflows from the inflows. Profit after tax and before depriciation is taken into account. NPV of the machine is calculated as below:-

Year	0	1	2	3	4
Annual Earnings before tax (A)		$200,000	$200,000	$200,000	$200,000
Purchase cost (B)	$200,000
Other cost (C)	$10,000+$50,000
Additional working capital (D)		$15,000
Annual cost (E)		$50,000	$50,000	$50,000	$50,000
Working capital released (F)					$15,000
Salvage value (G)					$40,000
Net inflows before tax (A-B-C-D-E+F+G)	-$260,000	$135,000	$150,000	$150,000	$205,000
less- Depriciation		66,000 (@33%)	90,000 (@45%)	30,000 @15%	14,000 @7%
Net inflows after depriciaton		69,000	60,000	120,000	191,000
Tax@40%		27,600	24,000	48,000	76,400
Profit after tax		41,400	36,000	72,000	114,600
Profit after tax before depriciation (P)	-260,000	107,400	126,000	102,000	128,600
NPV factor @10% (Q)	1	0.909	0.826	0.757	0.683
present value of cash flows (P multiply by Q)	-260,000	97,627	104,076	77,214	87,834

Net present value is:

The machine should be purchased as the NPV is positive.