Question

As owner of Falcon Airlines, you are considering the purchase of a new de-icing machine. The machine will be used to remove ice from the wings of Falcon’s planes during winter. The new machine will cost $98,000, shipping costs of $2,000, and also will require $3,000 in working capital to support the new machine’s operation. The equipment will be depreciated over a 3-year period using MACRS and will have an expected salvage value of $4,000 at the end of its expected economic life of four years. The annual savings associated with the machine are expected to be $25,000 per year for the next four years. The company will not deduct the salvage value from the machine’s cost when calculating depreciation. The existing de-icing machine is one year old but is not adequate for the company’s needs; it can be sold today for $40,000. The equipment was purchased for $60,000 and was being depreciated over a three-year period using the MACRS method. Falcon uses a hurdle rate of 11% for its capital budgeting projects and has a marginal tax rate of 30%. Determine whether you should purchase the new de-icing machine

Answer 1

	0	1	2	3	4
Savings in expenses		$         25,000	$        25,000	$     25,000	$       25,000
Incremental depreciation:
Depreciation of new equipment:
Rate of depreciation [%]		33.33	44.45	14.81	7.41	100
Depreciation expense		$         33,330	$        44,450	$     14,810	$         7,410
Depreciation of old equipment:
Rate of depreciation [%]		44.45	14.81	7.41	0	66.67
Depreciation expense		$         26,670	$           8,886	$       4,446	$                -
Incremental depreciation		$            6,660	$        35,564	$     10,364	$         7,410
Incremental EBIT		$         18,340	$       -10,564	$     14,636	$       17,590
Tax at 30%		$            5,502	$         -3,169	$       4,391	$         5,277
NOPAT		$         12,838	$         -7,395	$     10,245	$       12,313
Add: Depreciation		$            6,660	$        35,564	$     10,364	$         7,410
OCF		$         19,498	$        28,169	$     20,609	$       19,723
Capital expenditure [98000+2000]	$        1,00,000				$       -2,800	[4000*(1-30%)]
After tax sale value of old machine [See workings below]	$            40,000
Change in NWC	$              3,000				$       -3,000
FCF	$          -63,000	$         19,498	$        28,169	$     20,609	$       25,523
PVIF at 11% [PVIF = 1/1.11^n]	1	0.90090	0.81162	0.73119	0.65873
PV at 11%	$          -63,000	$         17,566	$        22,863	$     15,069	$       16,813	$                  9,311
NPV	$              9,311
AS THE NPV IS POSITIVE, THE NEW DE-ICING MACHINE SHOULD BE PURCHASED.
WORKINGS FOR AFTER TAX SALE VALUE OF OLD MACHINE:
Sale price	$            40,000
Book value = 60000-60000*.3333 =	$            40,002
No gain/No loss
After tax sale value of old machine =	$            40,000