Question

Global company is considering replacing one of its equipment with a more efficient one. The old machine has a book value of $60,000 and a remaining useful life of 5 years. It can sell the old machine now for $ 265,000. The old machine is being depreciated by 120,000 per year straight line. The new machine has a purchase price of $ 1,175,000 an estimated useful life and 5 years MACRS class life and salvage value of $145,000. Annual economic savings is $255,000 if new machine is installed. Taxes 40% and WACC is 12%. Show your work the best you can with this problem.

1. Calculate the initial cash flow at time 0, which is today.
2. Calculate the cash flows for years 1 thru 5.
3. Calculate the terminal value at year 5
4. Calculate the NPV and IRR of the project and make a decision on wheather the company should accept or reject the investment and why?

Answer 1

Time line		0	1	2	3	4	5
Proceeds from sale of existing asset	=selling price* ( 1 -tax rate)	159000
Tax shield on existing asset book value	=Book value * tax rate	24000
Cost of new machine		-1175000
=a. Initial Investment outlay		-992000
5 years MACR rate			20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
Savings			255000	255000	255000	255000	255000
-Depreciation	=Cost of machine*MACR%		-235000	-376000	-225600	-135360	-135360	67680	=Salvage Value
=Pretax cash flows			20000	-121000	29400	119640	119640
-taxes	=(Pretax cash flows)*(1-tax)		12000	-72600	17640	71784	71784
+Depreciation			235000	376000	225600	135360	135360
=b. after tax operating cash flow			247000	303400	243240	207144	207144
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						87000
+Tax shield on salvage book value	=Salvage value * tax rate						27072
=c. Terminal year after tax cash flows							114072
Total Cash flow for the period		-992000	247000	303400	243240	207144	321216
Discount factor=	(1+discount rate)^corresponding period	1	1.12	1.2544	1.404928	1.5735194	1.7623417
Discounted CF=	Cashflow/discount factor	-992000	220535.7	241868.6	173133.43	131643.76	182266.58
d. NPV=	Sum of discounted CF=	-42551.89407

Total Cash flow for the period		-992000	247000	303400	243240	207144	321216
Discount factor=	(1+discount rate)^corresponding period	1	1.102718	1.215986	1.3408898	1.478623	1.6305038
Discounted CF=	Cashflow/discount factor	-992000	223992	249509.4	181401.93	140092.51	197004.15
NPV=	Sum of discounted CF=	-0.000832087
IRR is discount rate at which NPV = 0 =	10.27%

Reject as NPV is negative and IRR is less than WACC