Company X is considering replacing an existing processor with a new processor th
ID: 2613442 • Letter: C
Question
Company X is considering replacing an existing processor with a new processor that costs $200,000. Shipping and setup costs for the new processor are estimated to be $15,000. X’s working capital requirement is expected to increase by $17,000 when the new processor begins operation and is expected to be fully recoverable at the end of the project. The new processor’s useful life is expected to be 5 years and its salvage value at that point is estimated to be $60,000. The old processor had an installed cost of $150,000 when it was placed in service three years ago and is also being depreciated using a 5-year ACRS life. The old processor can be sold today for $50,000. Estimated incremental revenues and incremental cash operating expenses for the
new processor before tax for each year are shown in the table below. Note that you will have to calculate the incremental depreciation for the two years of overlap of the expected lives of the old and new processors.
Note that there is an after tax salvage value both at the beginning and the end of this project. Assume a tax rate of 35% and a cost of capital of 12%. Show the calculations for the initial investment and the OCFAT for each year. Then use your financial calculator to find the NPV and IRR for the project. In addition to the OCFAT’s shown, indicate the value that you enter for
the initial investment, CF0, and the cost of capital, I. Based on the NPV and IRR, should company X invest in the new processor?
Explanation / Answer
Year 0 Cash Outflow Consists of:
Cost of new machine
200000+15000 = 215000
Working Capital requirement
17000
Salvage Value Realised On Old Machine
50000
Tax On Salage Value ( 50000– book value) * 35%
4550
Initial Outlay
=215000 + 17000 – 50000 -4550= 177450
Book value at year 3 = (100- 15 -22 -21 ) * 150000 = 63000
Cash Flows Year 1 to 5
Year
Incremental Revenue
Incremental Expenses
Depreciation On New machine
Old Machine Depreciation
Tax Saving On Incremental Depreciation
Cash Flows
a
b
c
d
e
f= (d –e) *35%
g = (b –c)(1 -0.35) +d
1
$87,000
$23,000
215000 * 15% = 32250
150000 *21% = 31500
262.50
$41,862.50
2
$82,000
$25,000
215000 * 22% = 47300
150000 *21% = 31500
5530
$42,580.00
3
$93,000
$30,000
215000 * 21% = 45150
0
15802.50
$56,752.50
4
$87,000
$23,000
215000 * 21% = 45150
0
15802.50
$57,402.50
5
$88,000
$29,000
215000 * 21% = 45150
0
15802.50
$54,152.50
Terminal Cash flow
Salvage value new machine = 60000
Working Capital Inflow = 17000
Book value of old machine = 0
Book value of new machine = 0
Profit on sale of new machine = 60000
Tax On salvage profit = 60000 * 0.35 = 21000
Terminal Cash Flow = 60000 + 17000 – 21000 = $ 56000
Using Our Financial Calculator ,
CF0 = -177450 , C01 = $41,862.50 , C02 = $42,580.00 , C03 = $56,752.50 , C04 = $57,402.50
C05 = $54,152.50 + 56000 = 110152.50
The above values discounted @ 12%, will give NPV = $ 33251
IRR = 18.19%
Since the NPV is positive, project will add value to the organization and hence project should be accepted
Also since IRR is greater than cost of capital, the project will add value to the organization.
Cost of new machine
200000+15000 = 215000
Working Capital requirement
17000
Salvage Value Realised On Old Machine
50000
Tax On Salage Value ( 50000– book value) * 35%
4550
Initial Outlay
=215000 + 17000 – 50000 -4550= 177450
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