Old Bread Company needs to purchase a new baking oven to replace an older oven t

Question

Old Bread Company needs to purchase a new baking oven to replace an older oven that requires too much energy to run. The industrial size oven will cost $1,200,000. The oven will be depreciated on a straight-line basis over its six year useful life. The old oven cost the company $800,000 just four years ago. The old oven is being depreciated on a straight-line basis over its expected ten year useful life. (That is, the old oven is expected to to last 6 more years if it is not replaced now.) Due to changes in the fuel costs, the old oven may only be sold today for $100,000. The Expenses will also decrease by $50,000 per year due to the more energy efficient design of the new oven. The premium pie company is in the 40% marginal tax bracket and has a required rate of return of 10%.a. Calculate the Net Present Value and Internal Rate of Return of replacing the existing machine. b. explain the impact on NPV on the following: i)Required rate of return increased. ii)Operating costs of new machine are increased. iii) Existing machine sold for less.

Please include all steps and calculations. I need to understand the process to learn.

Explanation / Answer

Net Present Value = Present value of incremental cash inflow- present value of incremental cash outflow

Incremental cash inflow = increase in cash profit due to reduced expenses -- tax on cash profit + tax benefit on depreciation
                                       = $50000 --$ 20000 (50000*40%) + $48000*
                                       = $ 78000
* tax benefit oin depreciation = incremental depreciation * tax rate
                                                     = [(1200000/6)-(800000/10)] * 40%
                                                      = 120000*40%
   = $ 48000  
PV of incremental cash flow of 6 years = 6 year cumulative PV of 1 at rate of 10% * incremental cash inflow per year
                                                                         = 4.355 * 78000
                                                                        = 3,39,600
i.e PV of incremental cash inflow for 6 year = $ 339,600

Incremental cash outflow = cost of new oven - sale value of old oven
                                                 =$1,200,000 - $ 100,000
                                                = $ 1,100,000
  
NPV = Present value of incremental cash inflow- present value of incremental cash outflow

          = $ 339600 - $ 1,100,000
          = - 760400
NPV is negative in this case.

2. IRR will be negative as the cash outflow is higher in this case

B. (i) if the required rate of return increases, it will resulted into reduction of discounted cash inflow. it will lead to decrease in NPV
(II) increase in operating cost of new machine will lead to decrease in cash inflow and in further, it will lead to decrease in NPV
(iii) existing machine sold for less will resulted into higher cash outflow and as a result NPV will decrease.

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