Question

TM company is considering replacing its machine with a new model that sells for $40,000, the cost of installation is $6,000. Net Working Capital needed would be $5,500. The old machine has been fully depreciated and has a $2500 salvage value. The new machine will be depreciated as a 5-year MACRS asset. Revenues are expected to increase $18,000 per year over the 5-year life of the new machine. At the end of 5 years, the new machine is expected to have a $1500 salvage value.

What are the NPV and IRR for this project if TM has a required rate of return of 14% and a marginal tax rate of 35%? Operating costs are not expected to increase from the current level of $8,000 per year. Discuss your recommendations to the company's CEO about the replacement.

Answer 1

Calculation of NPV and IRR of the project
Year	0	1	2	3	4	5
Investment in Machine	-$46,000
Increase in net working capital	-$5,500
Sale of old machine	$2,500
Tax @ 35% on Gain on sale	-$875
Operating cash flow		$14,920	$16,852	$14,791	$13,555	$13,555
Recovery of net working capital						$5,500
After tax sale value of machine						$1,902
Net Cash flow	-$49,875	$14,920	$16,852	$14,791	$13,555	$20,957
x Discount Factor @ 14%	1.00000	0.87719	0.76947	0.67497	0.59208	0.51937
Present Value	-$49,875	$13,088	$12,967	$9,984	$8,025	$10,884
NPV of project	$5,073
IRR of project	18.02%
Recommendation to Company's CEO
It is recommended to replace the old machine with new one as replacement project has positive NPV.
Working 1
Calculation of operating cash flow for the project over 5 years
Year	1	2	3	4	5
Increase in revenue	$18,000	$18,000	$18,000	$18,000	$18,000
Less : Depreciation	$9,200	$14,720	$8,832	$5,299	$5,299
Profit before tax	$8,800	$3,280	$9,168	$12,701	$12,701
Less : Tax @ 35%	$3,080	$1,148	$3,209	$4,445	$4,445
Add : Depreciation	$9,200	$14,720	$8,832	$5,299	$5,299
Operating Cash flow	$14,920	$16,852	$14,791	$13,555	$13,555
Working-2
Calculation of depreciation using 5 Year MACRS
Year	Depreciable value	Depreciation rates	Depreciation
1	$46,000	20.00%	$9,200
2	$46,000	32.00%	$14,720
3	$46,000	19.20%	$8,832
4	$46,000	11.52%	$5,299
5	$46,000	11.52%	$5,299
6	$46,000	5.76%	$2,650
Working-3
Calculation of after tax sale value of new machine
Sale value	$1,500
Less : Book value of machine [$46,000 - $43,350.40]	$2,650
Loss on sale of equipment	-$1,150
Tax benefit @ 35% on Loss	$402
After tax sale value [Sale value +Tax benefit]	$1,902