Question

A company is evaluating the purchase of Machine A. The new machine would cost $120,000 and would be depreciated for tax purposes using the straight-line method over an estimated ten-year life to its expected salvage value of $20,000. The new machine would require an addition of $30,000 to working capital. In each year of Machine A’s life, the company would reduce its pre-tax costs by $40,000. The company has a 12% cost of capital and is in the 35% marginal tax bracket. (using Excel)

a. Identify the incremental cash flows from investing in Machine A.

b. Calculate the investment’s net present value (NPV).

c. Calculate the investment’s internal rate of return (IRR).

d. Should the company purchase Machine A? Why or why not?

(Organizing cash flows, NPV, IRR) This problem follows Problem 13. It is now five years later. The company did buy Machine A, but just this week Machine β came on the market; Machine β could be purchased to replace Machine A. If acquired, Machine β would cost $80,000 and would be depreciated for tax purposes using the straight-line method over an estimated five-year life to its expected salvage value of $20,000. Machine β would also require $30,000 of working capital but would save an additional $20,000 per year in pre-tax operating costs. Machine A’s salvage value remains $20,000, but it could be sold today for $40,000.(USING EXCEL)

a. Identify the incremental cash flows from converting to Machine B.

b. Calculate this investment’s net present value (NPV).

c. Calculate this investment’s internal rate of return (IRR).

d. Should the company convert to Machine B? Why or why not?

Answer 1

PART A

a) Incremental Cash flow in the Excel Sheet

b) NPV= PV of cash inflows - Initial investment

Year	Saving in Cost	Taxes@35%	After Tax savings	Tax Saving on Depreciation (10000*0.35)	Working Capirtal	Salvage Value	Incrementals Cash flows	PV Factor @ 12%	PV
1	40000	14000	26000	3500			29500	0.8929	26339.2857
2	40000	14000	26000	3500			29500	0.7972	23517.2194
3	40000	14000	26000	3500			29500	0.7118	20997.5173
4	40000	14000	26000	3500			29500	0.6355	18747.7833
5	40000	14000	26000	3500			29500	0.5674	16739.0922
6	40000	14000	26000	3500			29500	0.5066	14945.6181
7	40000	14000	26000	3500			29500	0.4523	13344.3019
8	40000	14000	26000	3500			29500	0.4039	11914.5552
9	40000	14000	26000	3500			29500	0.3606	10637.9957
10	40000	14000	26000	3500	30000	20000	79500	0.3220	25596.8723
							PV of Cash Inflows		182780.2412
							Less: Initial Investment		150000.0000
							NPV		32780.2412

c) CAlculation of IRR. It is the rate at which present Valu eof Cash inflow is equal to present value of cash outflow. At 12% NPV is positive so now we need to calculate at NPV at higher rate to lower down the NPV. So use 18%

Year	Saving in Cost	Taxes@35%	After Tax savings	Tax Saving on Depreciation (10000*0.35)	Working Capirtal	Salvage Value	Incrementals Cash Flows	PV Factor @ 18%	PV
1	40000	14000	26000	3500			29500	0.8475	25000.0000
2	40000	14000	26000	3500			29500	0.7182	21186.4407
3	40000	14000	26000	3500			29500	0.6086	17954.6107
4	40000	14000	26000	3500			29500	0.5158	15215.7718
5	40000	14000	26000	3500			29500	0.4371	12894.7219
6	40000	14000	26000	3500			29500	0.3704	10927.7304
7	40000	14000	26000	3500			29500	0.3139	9260.7885
8	40000	14000	26000	3500			29500	0.2660	7848.1258
9	40000	14000	26000	3500			29500	0.2255	6650.9541
10	40000	14000	26000	3500	30000	20000	79500	0.1911	15189.6251
								PV of Cash Inflows	142128.7690
								Less: Initial Investment	150000.0000
								NPV	-7871.2310

Do Interpolation:

IRR = 16.84 %

d) Yes company should purchase the Machinery as NPV is Positive and IRR 16.84% is higher than cost of capital 12%.

PART B

a)Incrementals CAsh Flows in Excel below

b) NPV  

Year	Saving in Cost	Taxes@35%	After Tax savings	Tax Saving on Depreciation 12000*0.35	Working Capirtal	Salvage Value	Incrementals Cash Flows	PV Factor @ 12%	PV
1	20000	7000	13000	4200			17200	0.8929	15357.1429
2	20000	7000	13000	4200			17200	0.7972	13711.7347
3	20000	7000	13000	4200			17200	0.7118	12242.6203
4	20000	7000	13000	4200			17200	0.6355	10930.9109
5	20000	7000	13000	4200	30000	20000	67200	0.5674	38131.0847
								PV of Cash Inflows	90373.4935
								Sale of Machinery A	40000.0000
						Capital Loss on sale of Asset: BV - Sales 70000-40000=30000 Tax Saving on Capital loss 30000 x 0.35	10500.0000
								Less: Initial Investment	150000.0000
								NPV	-9126.5065

c) IRR : NPV is negative at 12% so Try with 8%

Year	Saving in Cost	Taxes@35%	After Tax savings	Tax Saving on Depreciation 12000*0.35	Working Capirtal	Salvage Value	Incrementals Cash Flows	PV Factor @ 8%	PV
1	20000	7000	13000	4200			17200	0.9259	15925.9259
2	20000	7000	13000	4200			17200	0.8573	14746.2277
3	20000	7000	13000	4200			17200	0.7938	13653.9145
4	20000	7000	13000	4200			17200	0.7350	12642.5135
5	20000	7000	13000	4200	30000	20000	67200	0.6806	45735.1908
								PV of Cash Inflows	102703.7725
								Sale of Machinery A	40000.0000
						Capital Loss on sale of Asset: BV - Sales 70000-40000=30000 Tax Saving on Capital loss 30000 x 0.35	10500.0000
								Less: Initial Investment	150000.0000
								NPV	3203.7725

Do Interpolation :

= 10.52%

d) Reject the proposal as its having Negative NPV and IRR 10.52% less than IRR.