Question

9) 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%.

a. Calculate the initial cash flow at time 0, which is today.

b. Calculate the cash flows for years 1 thru 5.

c. Calculate the terminal value at year 5

d. Calculate the NPV and IRR of the project and make a decision on whether the company should accept or reject the investment and why?

Answer 1

a)	After tax value of old machine				=	265000-(265000-60000)*40%
					=	183000
	Cash outflow today				=	1,175,000-183,000
					=	992000
b)	Calculation of Depreciation
		Year			1	2	3	4	5	6 (WDV )
		Rate			20%	32%	19.20%	11.52%	11.52%	5.72%
		Cost			1,175,000	1,175,000	1,175,000	1,175,000	1,175,000	1,175,000
		Dep			235000	376000	225600	135360	135360	67210
	Calculation of cash flow
		Year		1	2	3	4	5	total
		saving		255000	255000	255000	255000	255000
		dep		235000	376000	225600	135360	135360
		profit before tax		20000	-121000	29400	119640	119640
		tax		8000	-48400	11760	47856	47856
		profit after tax		12000	-72600	17640	71784	71784
		Cash flow		247000	303400	243240	207144	207144
		PVF @ 12%		0.8929	0.7972	0.7118	0.6355	0.5674
		Discounted CF		220535.7	241868.6	173133.4	131643.8	117539.1	884720.6
c)
	WDV at year 5 (dep for year 6)				=	67210
	After tax salvage value of machine after 5 years					=	145000-(145000-67210)*40%
							113884
	PV of salvage value today					=	113884*0.5674
						=	64617.78
d)	NPV			=	Dicounted CF+PV of terminal CF-cash outflow At year 0
				=	884720.6+64617.78-992000
				=	-42661.62
	IRR			=	10.2673%
	Company should reject the project as NPV is negative or IRR is less than WACC