Question

Jane is the production manager of Fancy Bakery in Macau. Currently she is reviewing

the possibility of replacing the old machinery in order to boost production capacity.

The old machinery was purchased six years ago at a total cost of $6.2

million. It has a ten-year economic life with four years remaining and

zero salvage value. If this machinery were to be sold today, it would

be worth $2,480,000. The company uses the straight line depreciation

method on all production machinery. The firm’s cost of capital is 18%

with a marginal tax rate of 25%.

The new machinery is proposed by Smart Consulting and its purchase

price would be $6.8 million. In addition, to acquire the new machinery,

HK Mills would have to incur $200,000 shipping and installation costs

and $500,000 investment in networking capital. The economic life of

the new machinery is four years with zero scrap value.

It is expected that the new machinery can reduce before-tax operating

expenses by $2.2 million every year. The company had paid $50,000

to Smart Consulting to obtain the assessment report regarding this

replacement recommendation.

Answer the following questions:

(a) What is the initial outlay associated with this proposed

purchase?

(b) What are the annual after-tax cash flows associated with this

proposed purchase, for years 1 to 3? What about the amount of

after-tax cash flow that should appear in year 4?

(c) Compute the net present value (NPV) of this replacement

decision. Would you suggest that Jane should purchase the

new machinery?

Answer 1

Book value old machine

Book value = (purchase price)*remaining life/total life
= (6200000)*4/10
= 2480000

Time line		0	1	2	3	4
Proceeds from sale of existing asset	=selling price* ( 1 -tax rate)	1860000
Tax shield on existing asset book value	=Book value * tax rate	620000
Cost of new machine		-7000000
Initial working capital		-500000
=a. Initial Investment outlay		-5020000
Savings			2200000	2200000	2200000	2200000
-Depreciation	Cost of equipment/no. of years		-1750000	-1750000	-1750000	-1750000
=Pretax cash flows			450000	450000	450000	450000
-taxes	=(Pretax cash flows)*(1-tax)		337500	337500	337500	337500
+Depreciation			1750000	1750000	1750000	1750000
=after tax operating cash flow			2087500.00	2087500	2087500	2087500
reversal of working capital						500000
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						500000
b. Total Cash flow for the period		-5020000	2087500	2087500	2087500	2587500
Discount factor=	(1+discount rate)^corresponding period	1	1.18	1.3924	1.643032	1.9387778
Discounted CF=	Cashflow/discount factor	-5020000	1769067.797	1499210	1270516.9	1334603.7
c. NPV=	Sum of discounted CF=	853398.4549

Accept project as NPV is positive