Question

Canal Company is contemplating the purchase of a new leather sewing machine to replace the existing machine. The existing machine was purchased four years ago at an installed cost of $115,000; it was being depreciated under MACRS using a 5-year recovery period. The existing machine is expected to have a useful life of 5 more years. The new machine costs $203,000 and requires $8,000 in installation costs; it has a five-year useable life and would be depreciated under MACRS using 5-year recovery period. Canal can currently sell the existing machine for $52,000 without incurring any removal or cleanup costs. To support the increased business resulting from purchase of the new machine, accounts receivable would increase by $63,000, inventories by $12,000, and accounts payable by $72,000. At the end of 5 years, the existing machine is expected to have a market value of zero; the new machine would be sold to net $66,000 after removal and cleanup costs and before taxes. The firm is subject to a 33% tax rate and a WACC of 13.36%. The estimated earnings before depreciation, interest, and taxes over the 5 years for both the new and the existing grinder are shown in the table.

Earnings before interest, taxes, depreciation and amortization

Year	New Machine	Existing Machine
1	$75,000	$36,000
2	$75,000	$33,000
3	$75,000	$30,000
4	$75,000	$27,000
5	$75,000	$24,000

Should Canal Company invest in the new machine?

Solve the problem in Excel, showing your work and making sure you answer the above question.

Answer 1

The incremental FCF and the NPV for the replacement project are worked out below:
	0	1	2	3	4	5
Incremental EBITDA:
New machine		75000	75000	75000	75000	75000
Existing machine		36000	33000	30000	27000	24000
Incremental EBITDA		39000	42000	45000	48000	51000
Incremental depreciation:
New machine		42200	67520	40512	24307	24307	198846
Old machine		13248	6624	0	0	0	19872
Incermental depreciation		28952	60896	40512	24307	24307
Incremental NOI		10048	-18896	4488	23693	26693
Tax at 33%		3316	-6236	1481	7819	8809
Incremental NOPAT		6732	-12660	3007	15874	17884
Add: Incremental depreciation		28952	60896	40512	24307	24307
Incremental OCF		35684	48236	43519	40181	42191
Capital spending:
Cost of new machine+installation cost	211000
After tax sale value of old machine = 52000-33%*(52000-19872) =	-41398
Net capital spending	169602					-48231
Change in NWC (63000+12000-72000)	3000					-3000
FCF	-172602	35684	48236	43519	40181	93422
PVIF at 13.36%	1	0.88215	0.77818	0.68647	0.60556	0.53420
PV at 13.36%	-172602	31479	37536	29874	24332	49906	525
NPV	525
DECISION:
As the NPV is positive, the Company should invest in the new machine.