Question

Acme Dry cleaning has an on-campus location with 5 years to go on its lease. An existing dry cleaning machine will last for the 5-year duration of the lease, at which time it will be worn out and worthless. A machine will be more efficient and will allow the company to handle a broader range of fabrics. As a result, the new machine will increase revenues by $1,500 a year and decrease operating costs (other than depreciation) by $600 per year.

The old machine was purchased two years ago (purchase price = $8,000) and has a 3-year life for depreciation purposes. The old machine could be sold today for $6,000. The new machine will cost $15,000, last 5 years, and has a 3-year life for depreciation purposes. The new machine is expected to have a re-sale value of $5,000 in 5 years (when the lease is up).

Since revenue are expected to increase, the company will need to keep an additional $250 of petty cash in the storee's cash register beginning at time 1. This petty cash balance will need to be increased by an additional 100$ at time 2. This $350 (250 + 100) will be removed at time 5.

Acme Dry cleaning is in the 40 percent tax bracket and uses straight line depreciation. The required return for projects of this risk class is 18%. Should Acme purchase the new machine? Provide a numerical solution.

Answer 1

For evaluating if purchase of new machine is a good decision or not , the Net present value of such action is to be calculated.

(All amounts in $)

Therefore, the net present value of the decision is = Sum of all year's Present Value

= (-9250 )+ 1694.92 + 1508.19  +1278.12+ 649.89 + 2889.29
= - $ 1229.59

Conclusion : The net present value of the decision is negetive. This implies that the company will loose money over the course of 5 year if it buys the new machine. Hence, the decision to buy the new machine is not feasible for the company.

Notes :

1. It has been assumed that there is no benifit of carrying over Tax Savings due to revenue Losses occuring in the year 1,2&3.
2. A cashflow basis is adopted for such desions, hence the Calculations for depriciation is done only to evaluate the tax impact.
3. Depriciation for old machine is only for the 1 year as the machine has a depriciable life of 3 years, out of which 2 years have already passed. It is calculated as following:
= (remaining life / Total life )* cost = (1/3)*$8000 = $2666.67
4.Depreiciation for new machine ( every year) is :
=1/3 * $15000 = $ 5000 per Annum for 3 years.