A firm is considering an investment in a new machine with a price of $13.5 milli

Question

A firm is considering an investment in a new machine with a price of $13.5 million to replace its existing machine. The current machine has a book value of $5.5 million and a market value of $4.5 million. The new machine is expected to have a four-year life, and the old machine has four years left in which it can be used. If the firm replaces the old machine with the new machine, it expects to save $6 million in operating costs each year over the next four years. Both machines will have no salvage value in four years. If the firm purchases the new machine, it will also need an investment of $400,000 in net working capital. The required return on the investment is 10 percent, and the tax rate is 40 percent. Assume the company uses straight-line depreciation.What is the NPV of the decision to purchase a new machine?What is the IRR of the decision to purchase a new machine?What is the NPV of the decision to keep the old machine?What is the IRR of the decision to keep the old machine?

Explanation / Answer

New Machine cost = 13.5m , Depreciation = 13.5/4 = 3.375m per year

After Tax Depreciation = 3.375*0.6= 2.025m per year

Old Machine = 5.5m, Annual dep on Old mach = 5.5/4 = 1.375

After tax dep = 1.375*0.6= 0.825

Annual savings of purchase of new Machine After Tax = 6(0.6) = 3.6

Total Savings Annual after tax = 3.6-(2.025-0.825) = 2.4m

PVAF=3.17

NPV of purchasing new mach = 3.17(2.4) - 0.4 - 13.5 + 4.5 = (1.79)m

IRR of purchase of new Mach = (Outflow = Inflow) = 0.85%

NPV to keep the old Machine = 1.79m

IRR to keep the old Machine can't be calculated as there is no Outflow

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