Question

Big Rock Brewery currently rents a bottling machine for $ 50 comma 000 per​ year, including all maintenance expenses. The company is considering purchasing a machine instead and is comparing two alternate​ options: option a is to purchase the machine it is currently renting for $ 160 comma 000​, which will require $ 20 comma 000 per year in ongoing maintenance​ expenses, or option​ b, which is to purchase a​ new, more advanced machine for $ 265 comma 000​, which will require $ 18 comma 000 per year in ongoing maintenance expenses and will lower bottling costs by $ 13 comma 000 per year.​ Also, $ 36 comma 000 will be spent upfront in training the new operators of the machine. Suppose the appropriate discount rate is 7 % per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each​ year, as is the rental of the machine. Assume also that the machines are subject to a CCA rate of 25 % and there will be a negligible salvage value in 10​ years' time​ (the end of each​ machine's life). The marginal corporate tax rate is 40 %. Should Big Rock Brewery continue to​ rent, purchase its current​ machine, or purchase the advanced​ machine? To make this​ decision, calculate the NPV of the FCF associated with each alternative.​ (Note: the NPV will be​ negative, and represents the PV of the costs of the machine in each​ case.)

Answer 1

The Net Present Value of Rental Option is -$210,707

The Net Present Value of Option 1, purchasing the current machine is -$195,714

The Net Present Value of Option 2, purchasing the advanced machine is -$241,629

The Net Present Value of Option 1, purchasing the current machine is the lowest among the other alternatives. Hence Big Rock Brewery should purchase its current machine.

Note:

1. Depreciation is given as 25% CCA. Thus, depreciation per annum will be 25% of the closing book value of the previous year

2. Question mentions that there will be a negligible salvage value in 10​ years' time. Thus, any impact on loss or profit on the salvage value is not considered.

Workings: