In order to increase production capacity, Gunning Industries is considering repl

Question

In order to increase production capacity, Gunning Industries is considering replacing an existing product machine with a new technologically improved machine on January 1, 2019. The following information is being considered by Management:

The new machine would cost $160,000 in cash. Shipping, installation, and testing wold cost an additional $30,000.

The new machine is expected to increase annual sales by 20,000 units at a sales price per unit of $40 each.

Associated incremental operating costs include $30 per unit in variable costs and total fixed cost of $40,000 per year.

The new machine investment will require an immediate additional working capital of $35,000, which is expected to be recovered at the end of year 5.

Gunning uses a straight-line method of depreciation for financial reporting purposes and tax reporting purposes. The new machine has a life of 5 years and no salvage value

Gunning is subject to a 40% tax rate.

Gunning’s cost of capital is 10%

1. Gunning’s net cash outflow in this project is:

a. $190,000

b. $195,000

c. $204.525

d. $225,000

2. Gunning’s discounted annual depreciation tax shield for the year 2019 is:

a. $13,817

b. $16,762

c. $20,725

d. $22,800

3. The new machine will contribute a discounted net-of-tax contribution margin of:

a. $242,624

b. $303,280

c. $363,936

d. $454,920

4. The overall discounted cash flow impact of the working capital for the new machine is:

a. $(7,969)

b. $(10,080)

c. $(13,265)

d. $(35,000)

5. What is the payback period for this new machine:

6. What is the Net Present Value of this plan to purchase the new machine:

7. What is the Profitability Index of this plan to purchase the new machine:

8. What is the Internal rate of return for this replacement plan:

Explanation / Answer

1.Net Cash Outflow = 160000+30000+35000 = 225000

i.e. d

2.Depreciation on the basis of SLM with life of 5 years = 190000/5 = 38000

Tax Shield (tax saving on depreciation) = 38000*40%

=15200

Discounted tax shield for 2019 = 15200*PVF(10%, 1 year)= 15200*0.909 =$13817

i.e. a

3.Contributuion Margin = Sales – VC

= 20000*(40-30) = 200000

Less: Tax @ 40% 80000

Contribution Margin after Tax = 120,000

PV for % years = 120,000*3.791 = $454,920

i.e. d

4.Working capital introduced in Year 0, released at the end of year 5

Net Impact = -35000+ 35000*0.621 =(13265)

i.e. c

5. Payback period = Initial Cost/Annual Inflows

Annual Inflows = (Contribution – Fixed Cost – Dep)(1-tax rate) + Dep

=(200000-40,000-38000)(1-.4)+38000 = 111200

Payback period = 225000/111200 = 2.02 years

6. NPV = Present value of cash inflows – Present Value of Cash Outflows

= 111200*3.791 + 35000*0.621 – 225000

=218294.2

7. Profitability Index = Present Value of Cash Inflows/Initial Outflow

= 443294.2/225000 = 1.97

8. IRR is the rate at which NPV = 0

i.e. Present Value of Cash Inflows = Present Value of Cash Outflows

Let r= 20%

NPV = 111200*2.99+35000*0.402 – 225000

=121558

Let r = 40%

NPV = 226292+6510 – 225000 = 7802

At r = 45%

NPV = 208611.2+5460-225000 = -10928.8

Therefore, using interpolation technique ,

IRR = 40% + (7802/18730.8)*5

= 42.08%

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