Question

Burton, a manufacturer of snowboards, is considering replacing an existing piece of equipment with a more sophisticated machine. The following information is given. · The proposed machine will cost $120,000 and have installation costs of $20,000. It will be depreciated using a 3 year MACRS recovery schedule. It can be sold for $60,000 after three years of use (before tax; at the end of year 3).

The existing machine was purchased two years ago for $95,000 (including installation). It is being depreciated using a 3 year MACRS recovery schedule. It can be sold today for $20,000. It can be used for three more years, but after three more years it will have no market value.

The earnings before taxes and depreciation (EBITDA) are as follows: o New machine: Year 1: 133,000, Year 2: 96,000, Year 3: 127,000 o Existing machine: Year 1: 84,000, Year 2: 70,000, Year 3: 74,000

Burton pays 40 percent taxes on ordinary income and capital gains, and uses a WACC of 14%. · The maximum payback period allowed is 3 years.

They expect a large increase in sales so their Net Working Capital will increase by $20,000 when they buy the machine and it will be recovered at the end of the project life.

a. Calculate the initial investment required for this project.

b. Determine the incremental after-tax operating cash flows

c. Find the terminal cash flow for the project

d. Find the Discounted Payback period, NPV, IRR, and MIRR.

e. Should the new machine be purchased? Why or why not?

Answer 1

All financials below are in $.

For the old machine, it has completed two years of depreciation.

Value remaining after 2 years of depreciation = (1 - 33.33% - 44.45%) = 22.22% = 22.22% x 95,000 =  21,109

Sale Price today = 20,000

Hence, post tax salvage value = Salvage value - (Salvage value - tax basis) x tax rate = 20,000 - (20,000 - 21,109) x 40% =  20,443.60

a. Calculate the initial investment required for this project.

Initial investment = Purchase price of new machine + installment cost of new machine - Post tax salvage value of old machine + investment in working capital = 120,000 + 20,000 - 20,443.60 + 20,000 =  139,556.40

b. Determine the incremental after-tax operating cash flows

Year	Linkage	0	1	2	3
Depreciation rate for new machine	d1		33.33%	44.45%	14.81%
Depreciable base	A1	140,000
EBITDA	Given		133,000	96,000	127,000
[-] Depreciation	D1 = A1 x d1		(46,662)	(62,230)	(20,734)
EBIT	EBITDA - D1		86,338	33,770	106,266
NOPAT	EBIT x (1 - 40%)		51,803	20,262	63,760
OCF	C1 = NOPAT + D1		98,465	82,492	84,494
Old Machine Cost	A2	95,000
Depreciation rate	d2		14.81%	7.41%	0%
EBITDA	Given		84,000	70,000	74,000
[-] Depreciation	D2 = A2 x d2		(14,070)	(7,040)	-
EBIT	EBITDA - D2		69,931	62,961	74,000
NOPAT	EBIT x (1 - 40%)		41,958	37,776	44,400
OCF	C2 = NOPAT + D2		56,028	44,816	44,400
Incremental cash flows	C= C1 - C2		42,437	37,676	40,094

Part (c)

Terminal cash flows = Post tax salvage value new machine + release of working capital - opportunity cost of salvage value of old machine

Post tax salvage value of new machine = 60,000 - (60,000 - 140,000 x 7.41% ) x 40% =  40,149.60

Hence, terminal cash flow =  40,149.60 + 20,000 - 0 =  60,149.60

Part (d)

Cash flows can now be arranged as shown below.

Discount rate, R = 14%

Discount factor for year N = (1 + R)^-N

Discounted payback period = Never, the project never achieves break even on discounted cash flow over t = 3 years

NPV, IRR and MIRR can be seen in the table above in yellow colored cells. Adjacent cells in blue contain the excel formula.

Part (e)

NPV is negative.

Payback period is greater than allowed limit.

IRR < WACC

Hence, the new machine should not be purchased.