Question

1. 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: oNew machine: Year 1: 133,000, Year 2: 96,000, Year 3: 127,000 oExisting 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

	1-	cost of new machine with installation			-140000
		sale proceeds of old machine			20000			purchase price of old machine		95000
		tax credit on loss on sale of old machine			443.6			accumulated depreciation		73891
		Investment in working capital			-20000			book value at the end of 2nd year		21109
		net initial investment			-139556.4			selling price of old machine		20000
								loss on sale of old macine		-1109
	Year	0	1	2	3			tax credit on loss on sale of old machine	1109*40%	443.6
	net initial investment	-139556.4
	incremental EBITDA		49000	26000	53000		Year	cost of machine	Macrs rate	annual depreciation
	less incremental depreciation		32592.5	55190.5	20734		1	95000	33.33%	31663.5
	EBIT		16407.5	-29190.5	32266		2	95000	44.45%	42227.5
	less taxes-40%		6563	-11676.2	12906.4					73891
	Incremental earning after tax		9844.5	-17514.3	19359.6
	add incremental depreciation		32592.5	55190.5	20734		Year	cost of new machine	Mars rate	annual depreciation
	add recovery of working capital				20000		1	140000	33.33%	46662
	add after tax sale proceeds of machine				40149.6		2	140000	44.45%	62230
2-	net operating cash flow	-139556.4	42437	37676.2	100243.2		3	140000	14.81%	20734
	present value of net operating cash flow = net operating cash flow/(1+r)^n r= 14%	-139556/1.14^0	42437/1.14^1	37676.2/1.14^2	100243.2/1.14^3		Accumulated depreciation on new machine			129626
	present value of net operating cash flow = net operating cash flow/(1+r)^n r= 14%	-139556	37225.439	28990.612	67661.3047
4-	net present value = sum of present value of operating cash flow		-5678.6442				depreciation on old machine
	IRR = Using IRR function in MS excel	IRR(P349:S349)	11.90%				Year	cost of new machine	Mars rate	annual depreciation
	MIRR - Using MIRR function in MS Excel	MIRR(P349:S349,14%,14%)	12.43%				3	95000	14.81%	14069.5
							4	95000	7.41%	7039.5
	Discounted payback period
	sum of discounted value of cash flow	-5678.644214					Incremental depreciation
	so entire amount of discounted Initial investent is not recovered from discounted net cash inflow so there is a shortage of -5678.64 so discounted payback period will more than 3 years to recover the remaining cost of -5678.64						Year	new machine	old machine	Incremental depreciation
							1	46662	14069.5	32592.5
5-	New machine should not be purchased as NPV is negative, IRR and MIRR are less than the required return of 14% and discounted payback period will be more than expected payback period of 3 year to recover entire cost.						2	62230	7039.5	55190.5
							3	20734	0	20734
3-	terminal cash flow
	recovery of working capital	20000					Incremental EBITDA
	add after tax sale proceeds of machine	40149.6					Year	new machine	old machine	Incremental EBITDA
	terminal cash flow	60149.6					1	133000	84000	49000
							2	96000	70000	26000
							3	127000	74000	53000
							Book value of new machine at the end of year 3	cost of machine - accumulated depreciation	140000-129626	10374
							sale price of new machine		60000
							gain on sale of new machine	60000-10374	49626
							tax on gain of old machine	49626*40%	19850.4
							net sale proceeds of old machine	60000-19850.4	40149.6