Progress Incorporated is considering buying a new machine to increase production

Question

Progress Incorporated is considering buying a new machine to increase production. It will cost $200,000 to purchase, $10,000 to modify and $5,000 to have it installed. It has a five-year class life. At the end of three years they plan to sell the machine for $95,000. The new machine will allow Progress to increase revenues by $80,000 each year but expenses will increase by $5,000 each year. Inventory will decrease by $6,000 and wages payable will increase by $2,000 if the machine is purchased. Straight-line depreciation will be used. Progress’s marginal tax rate is 34% and its cost of capital is 7%. Should PI purchase the new machine? Complete the following parts:

Explanation / Answer

We can decide whether PI should purchase the machine or not based on Net present value criteria. If NPV of the proposal turns out positive, PI should purchase the new machine otherwise not. Calculation of net present value of new machine Year 0 1 2 3 NPV Installed cost of new machine -$215,000.00 Decrease in net working capital $8,000.00 Increase in net working capital -$8,000.00 Operating cash flow $64,120.00 $64,120.00 $64,120.00 After tax Salvage value of machine $91,940.00 Net Cash flow -$207,000.00 $64,120.00 $64,120.00 $148,060.00 x Discount factor @ 7% 1 0.9345794 0.8734387 0.81629788 Present Values -$207,000.00 $59,925.23 $56,004.89 $120,861.06 $29,791.19 As the NPV of new machine is positive , PI should purchase the new machine. Working Calculation of operating cash flow of the new machine per year Increase in revenue $80,000.00 Less : Increase in expense $5,000.00 Less : Depreciation $43,000.00 Profit before tax $32,000.00 Less : Tax @ 34% $10,880.00 Add : Depreciation $43,000.00 Operating cash flow $64,120.00 Depreciation per year using straight line method = (Installed cost - residual value) / useful life Depreciation per year using straight line method = ($215000 - $0) / 5 years = $43000 After tax salvage value of machine at the end of 3rd year Sale value of machine $95,000.00 Less : Book value at the end of 3rd year $86,000.00 [$215000 - $129000] Profit on sale $9,000.00 Tax on profit @ 34% $3,060.00 After tax salvage value [Sale value - Tax] $91,940.00

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