Question

King Fisher Aviation is considering an investment in a new technology for a drone project with a price of $16 million. Their current technology has a book value of $5 million and a market value of $5 million. The new technology is expected to have a five (5) year life, and the old technology has three (3) years left in which it can be expected to be used. If the firm replaces the old technology with the new technology it expects to save $5.7 million in operating costs each year over the next four years. If the firm purchases the new technology, it will also need an investment of $300,000 in net working capital. The required return on the investment is 12 percent, and the tax rate is 39 percent.

What are your recommendations on the investment project? Explain your reasoning.

Answer 1

Statement showing NPV

Particulars	0	1	2	3	4	5	NPV
Purchase price of equipment	-16000000
Salvage value of old machine	5000000
WC requirement	-300000
Savings in operating cost		5700000	5700000	5700000	5700000
depreciation		-3200000	-3200000	-3200000	-3200000	-3200000
PBT		2500000	2500000	2500000	2500000	-3200000
Tax @39%		975000	975000	975000	975000	-1248000
PAT		1525000	1525000	1525000	1525000	-1952000
Add depreciation		3200000	3200000	3200000	3200000	3200000
Annual cah flow		4725000	4725000	4725000	4725000	1248000
Release of WC						300000
Total cash flow	-11300000	4725000	4725000	4725000	4725000	1548000
PVIF @ 12%	1.0000	0.8929	0.7972	0.7118	0.6355	0.5674
Present value	-11300000	4218750	3766741	3363162	3002823	878376.8	3929852

Statement showing IRR

Particulars	0	1	2	3	4	5	NPV
Purchase price of equipment	-16000000
Salvage value of old machine	5000000
WC requirement	-300000
Savings in operating cost		5700000	5700000	5700000	5700000
depreciation		-3200000	-3200000	-3200000	-3200000	-3200000
PBT		2500000	2500000	2500000	2500000	-3200000
Tax @39%		975000	975000	975000	975000	-1248000
PAT		1525000	1525000	1525000	1525000	-1952000
Add depreciation		3200000	3200000	3200000	3200000	3200000
Annual cah flow		4725000	4725000	4725000	4725000	1248000
Release of WC						300000
Total cash flow	-11300000	4725000	4725000	4725000	4725000	1548000
PVIF @ 26.71677%	1.0000	0.7892	0.6228	0.4915	0.3878	0.3061
Present value	-11300000	3728788	2942616	2322200	1832591	473805.9	0

At 26.71677% , NPV is 0, hence IRR is 26.71677%