Question

The Startracks corporation is considering the purchase of new equipment to replace some old, existing equipment. The old equipment is fully depreciated and has a current market value of $1.2M. The new equipment costs $10.4M and will be depreciated using the 5 year MACRS class. The equipment is used to produce items with constant annual revenues of $18M. Current costs (using the old equipment) are $3M per year. The new equipment will not change the expected revenues (they will remain at $18M per year), but will allow the company to cut costs by $1M per year. The project is expected to last for 4 years, at which time the new equipment would be worth $6.0M. If the old equipment is kept, it will be worthless in 4 years. The company's marginal tax rate is 35%. The company is financed with $50M of preferred stock and $150M of common stock. The preferred stock has a current value of $20 and pays constant dividends of $2 annually. The expected return on the common stock is 14.4%. Should the project be accepted?

Answer 1

First we need to calculate the Weighted Average Cost of Capital for the company:

Evaluating returns while puchasing New Equipment:

Evaluating returns while using the Old Equipment:

Since NPV of using Old Machine $28,821,248.61 is greater as compared to plan of replacing it with a new machine, hence Startracks should reject the project.

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