Question

You want to buy a new piece of equipment for your business that costs $500,000.

You believe you can use the equipment to increase your gross profit by $45,000 each year for the next 15 years. The equipment will be depreciated over 10 years using straight-line depreciation and the half-year convention.

Insurance for the new equipment will cost $150 per month. Utility and maintenance expense to support the new equipment will amount to $1,000 per month. Your business’ income tax rate is 28%. You think you will need to borrow some of the money to buy this equipment, but you are not sure how much, so you have decided to use the interest rate for such a loan (6%, as indicated by your lender) as the discount rate for your calculations.

Based on this information, should you purchase the new equipment? Use the NPV and IRR methods to determine your answer.

Answer 1

	Depreciation straight line for 10 years
	Depreciation per year = cost/10	$50,000.00
	Calculation of cash flows
	Particulars	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
1	Gross profit		$45,000.00	$90,000.00	$1,35,000.00	$1,80,000.00	$2,25,000.00	$2,70,000.00	$3,15,000.00	$3,60,000.00	$4,05,000.00	$4,50,000.00	$4,95,000.00	$5,40,000.00	$5,85,000.00	$6,30,000.00	$6,75,000.00
2	Insurance(150*12)		$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00	$1,800.00
3	Utility and maintenance(1000*12)		$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00
4	Depreciation(straight line and half-year convention)		$25,000.00	$50,000.00	$50,000.00	$50,000.00	$50,000.00	$50,000.00	$50,000.00	$50,000.00	$50,000.00	$50,000.00	$25,000.00	$0.00	$0.00	$0.00	$0.00
5	EBIT=1-2-3-4		$6,200.00	$26,200.00	$71,200.00	$1,16,200.00	$1,61,200.00	$2,06,200.00	$2,51,200.00	$2,96,200.00	$3,41,200.00	$3,86,200.00	$4,56,200.00	$5,26,200.00	$5,71,200.00	$6,16,200.00	$6,61,200.00
6	tax @ 28%		$1,736.00	$7,336.00	$19,936.00	$32,536.00	$45,136.00	$57,736.00	$70,336.00	$82,936.00	$95,536.00	$1,08,136.00	$1,27,736.00	$1,47,336.00	$1,59,936.00	$1,72,536.00	$1,85,136.00
7	PAT=5-6		$4,464.00	$18,864.00	$51,264.00	$83,664.00	$1,16,064.00	$1,48,464.00	$1,80,864.00	$2,13,264.00	$2,45,664.00	$2,78,064.00	$3,28,464.00	$3,78,864.00	$4,11,264.00	$4,43,664.00	$4,76,064.00
8	Cash flow after tax=7+4	-$5,00,000.00	$29,464.00	$68,864.00	$1,01,264.00	$1,33,664.00	$1,66,064.00	$1,98,464.00	$2,30,864.00	$2,63,264.00	$2,95,664.00	$3,28,064.00	$3,53,464.00	$3,78,864.00	$4,11,264.00	$4,43,664.00	$4,76,064.00
9	Discount factor @ 6%	1	0.9434	0.89	0.84	0.79	0.75	0.70	0.67	0.63	0.59	0.56	0.53	0.50	0.47	0.44	0.42
10	PV of cash flows	-$5,00,000.00	$27,796.23	$61,288.71	$85,023.21	$1,05,874.41	$1,24,092.68	$1,39,909.29	$1,53,537.75	$1,65,175.09	$1,75,003.07	$1,83,189.22	$1,86,200.43	$1,88,283.80	$1,92,816.61	$1,96,233.02	$1,98,644.87
11	IRR	20%
12	NPV=Sum of PV of cash flows	$16,83,068.38

Since NPV is positive and IRR is greater than discount rate, the machine should be purchased.