Question

Princess Cruise Lines owns five cruise ships that operate continuously in the Caribbean Sea.

As the chief financial officer, you are considering the purchase of a new machine to remove barnacles from the bottom of the ships when they are in dry dock.

Princess currently owns a machine which will provide this same function, but the machine is old (3 years old) and tends to break down a lot. This machine can be sold today for $160,000, and yes, you’ll pay some gains taxes on it. The equipment was purchased three years ago for $2,600,000 and is being depreciated over a three-year period using the MACRS method.

The new machine will cost $3,500,000, has shipping costs of $18,000 (this is added to the depreciable basis), and also will require $37,000 in working capital to support the new machine’s operation. The equipment will be depreciated using 3-year MACRS and will have an expected salvage value of $120,000 at the end of its expected economic life of four years. The working capital will also be recouped at this time.

The annual operating expense savings associated with the machine are expected to be $1,000,000 per year for the next four years. Assume a 25% tax rate. Assume any negative taxes can be immediately used as a tax credit, which makes negative taxes functionally = a positive cash flow.

1. Determine whether you should purchase the new barnacle removing machine by conducting a capital budgeting analysis using [email protected]% and IRR. What is your recommendation?

Answer 1

Value of old asset	$        2,600,000
Depreciation (33.33%+44.45%+14.81%)	$        2,407,340
Book value	$            192,660
Sales value	$            160,000
Loss on sale	$            (32,660)
Tax gain (25%)	$                8,165

Depreciation Tax shield		Year 1	Year 2	Year 3	Year 4
Cost	3500000
Shipping	18000
Salvage	-120000
Depreciation base	3398000
Depreciation rate		33.33%	44.45%	14.81%	7.41%
Depreciation		1132553	1510411	503243.8	251791.8
Depreciation Tax shield Depreciation x tax rate)		283138.4	377602.8	125811	62947.95

	Year 0	Year 1	Year 2	Year 3	Year 4
Tax gain on sale of old Machine	$                  8,165
New Machine	$       (3,500,000)				$            120,000
Shipping cost	$             (18,000)
Working capital	$             (37,000)				$              37,000
Annual savings		$        1,000,000	$        1,000,000	$        1,000,000	$        1,000,000
Tax (25%)		$         (250,000)	$         (250,000)	$         (250,000)	$         (250,000)
Net Savings after tax		$            750,000	$            750,000	$            750,000	$            750,000
Depreciation tax shield		$            283,138	$            377,603	$            125,811	$              62,948
Net savings		$        1,033,138	$        1,127,603	$            875,811	$            812,948
PV Factor (1/(1+r)^n) - 9.3%	1	0.914913083	0.83706595	0.765842589	0.700679405
PV of Savings (Savings x PV factor)	$       (3,546,835)	$            945,232	$            943,878	$            670,733	$            569,616
NPV	($417,376.13)
IRR	3.53%

As Net Present Value is Negative. It is recommendable not to change the Machine. Management has to come up with alternatives as the Machine has already completed it's useful life.