Question

Assume Corbins ,Inc purchased an automated machine 5 years ago that had an estimated economic life of 10 years. The Automated Machines originally cost $300,000 and has been fully depreciated, leaving a current book value of $0. The actual market value of this drill press is $80,000. The company is considering replacing the automated machine with a new one costing $380,000. Shipping and installation charges will add an additional $10,000 to the cost. Corbins., Inc also has paid a sunk cost $25,000. The new machine would be depreciated to zero on a straight-line basis. The new machine is expected to have a 5-year economic life, and its actual salvage value at the end of the 5-year period is estimated to be $50,000. Corbin’s current marginal tax rate is 40 percent. Corbins., Inc expects annual revenues during the project’s first year to increase from $140,000 to $170,000 if the new drill press is purchased. After the first year, revenues from the new project are expected to increase a rate of $4,000 a year for the remainder of the project life. Assume further that while the old automated machine required two operators, the new drill press is more automated and needs only one, thereby reducing annual operating costs from $80,000 to $40,000 during the project’s first year. After the first year, annual operating costs of the new drill press are expected to increase by $2,000 a year over the remaining life of the project. The old automated machine is fully depreciated, whereas the new machine will be depreciated on the straight-line basis. The marginal Tax rate of 40 percent applies. Assume also that the company’s net working capital does change as a result of replacing the automated machine will increase by $10,000 per year over the life of the project. Should Corbins, Inc. accepts the project? Justify your answer based on your computation for NPV (using 10 percent-required return) and IRR.

Answer 1

Required rate of return	10%
Tax rate	40%

Year	0	1	2	3	4	5
Additional cash flows from new drill
Sale of older drill	80,000.00
Carrying cost of older drill	-
Profit from sale	80,000.00
After tax profit	48,000.00
Cost of new drill	380,000.00
Installation charge	10,000.00
Total capital expenditure	390,000.00
Salvage value						50,000.00
Carrying cost of older drill						-
Profit from sale						50,000.00
After tax profit						30,000.00
Additional revenue		30,000.00	34,000.00	38,000.00	42,000.00	46,000.00
Saves in revenue		40,000.00	38,000.00	36,000.00	34,000.00	32,000.00
Additional Operating profit		70,000.00	72,000.00	74,000.00	76,000.00	78,000.00
Tax on operating profit		28,000.00	28,800.00	29,600.00	30,400.00	31,200.00
After tax operating profit		42,000.00	43,200.00	44,400.00	45,600.00	46,800.00
Depreciation		78,000.00	78,000.00	78,000.00	78,000.00	78,000.00
Tax shield on depreciation		31,200.00	31,200.00	31,200.00	31,200.00	31,200.00
FCFF	(342,000.00)	73,200.00	74,400.00	75,600.00	76,800.00	108,000.00
IRR	5.83%
Discounted PV	(342,000.00)	66,545.45	61,487.60	56,799.40	52,455.43	67,059.50
NPV	(37,652.61)

analysis. The after tax salvage value is added to the FCFF in case of both older and newer drills. The IRR of the new drill is lower than the required rate of return. Consequently, the NPV of the project is -ve negative. Hence, this project is not profitable.