Beryl\'s Iced Tea currently rents a bottling machine for $50,000 per year, inclu

Question

Beryl's Iced Tea currently rents a bottling machine for $50,000 per year, including all maintenance expenses. It is considering purchasing a machine instead and is comparing two options: a. Purchase the machine it is currently renting for $165,000. This machine will require $22,000 per year in ongoing maintenance expenses b. Purchase a new, more advanced machine for $255,000. This machine will require $18,000 per year in ongoing maintenance expenses and will lower bottling costs by $10,000 per year. Also, $40,000 will be spent up front to train the new operators of the machine Suppose the appropriate discount rate is 7% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each year, as is the cost of the rental machine. Assume also that the machines will be depreciated via the straight-line method over seven years and that they have a 10-year life with a negligible salvage value. The marginal corporate tax rate is 30% Should Beryl's Iced Tea continue to rent, purchase its current machine, or purchase the advanced machine? To make this decision, calculate the NPV of the FCF associated with each alternative

Explanation / Answer

Alternative A: NPV of current Machine Year Cash Flow (Rent) Tax Rate @30%; 50,000 x 30% Future Cash Flow present value @7% present value of cash flows 0 0 0 $0.00 1 0 1 -$50,000 15000 -$35,000.00 0.9346 -$32,710.28 2 -$50,000 15000 -$35,000.00 0.8734 -$30,570.36 3 -$50,000 15000 -$35,000.00 0.8163 -$28,570.43 4 -$50,000 15000 -$35,000.00 0.7629 -$26,701.33 5 -$50,000 15000 -$35,000.00 0.7130 -$24,954.52 6 -$50,000 15000 -$35,000.00 0.6663 -$23,321.98 7 -$50,000 15000 -$35,000.00 0.6227 -$21,796.24 8 -$50,000 15000 -$35,000.00 0.5820 -$20,370.32 9 -$50,000 15000 -$35,000.00 0.5439 -$19,037.68 10 -$50,000 15000 -$35,000.00 0.5083 -$17,792.23 NPV -$245,825.35 Alternative B: NPV of Purchase Current Machine Year Capital Expenditure Maintenance Depreciation Maintaince after Tax Rate @30%; -22,000 x 30% Depreciation Tax shield Future Cash Flow present value @7% present value of cash flows 0 -$165,000.00 0 0 -$165,000.00 1 -165000 1 -$22,000.00 $23,571.43 -$15,400.00 $7,071.43 -$8,328.57 0.9346 -$7,783.71 2 -$22,000.00 $23,571.43 -$15,400.00 $7,071.43 -$8,328.57 0.8734 -$7,274.50 3 -$22,000.00 $23,571.43 -$15,400.00 $7,071.43 -$8,328.57 0.8163 -$6,798.60 4 -$22,000.00 $23,571.43 -$15,400.00 $7,071.43 -$8,328.57 0.7629 -$6,353.83 5 -$22,000.00 $23,571.43 -$15,400.00 $7,071.43 -$8,328.57 0.7130 -$5,938.16 6 -$22,000.00 $23,571.43 -$15,400.00 $7,071.43 -$8,328.57 0.6663 -$5,549.68 7 -$22,000.00 $23,571.43 -$15,400.00 $7,071.43 -$8,328.57 0.6227 -$5,186.62 8 -$22,000.00 -$15,400.00 -$15,400.00 0.5820 -$8,962.94 9 -$22,000.00 -$15,400.00 -$15,400.00 0.5439 -$8,376.58 10 -$22,000.00 -$15,400.00 -$15,400.00 0.5083 -$7,828.58 NPV -$235,053.18 Alternative c: NPV of Purchase Advanced Machine Year Capital Expenditure Maintenance Depreciation Maintaince after Tax Rate @30%; -18,000 x 30% other Cost after 30% tax Depreciation Tax shield Future Cash Flow present value @7% present value of cash flows 0 -$255,000.00 0 -$28,000.00 0 -$283,000.00 1 -$283,000.00 1 -$18,000.00 $36,428.57 -$12,600.00 $7,000.00 $10,928.57 $5,328.57 0.9346 $4,979.97 2 -$18,000.00 $36,428.57 -$12,600.00 $7,000.00 $10,928.57 $5,328.57 0.8734 $4,654.18 3 -$18,000.00 $36,428.57 -$12,600.00 $7,000.00 $10,928.57 $5,328.57 0.8163 $4,349.70 4 -$18,000.00 $36,428.57 -$12,600.00 $7,000.00 $10,928.57 $5,328.57 0.7629 $4,065.14 5 -$18,000.00 $36,428.57 -$12,600.00 $7,000.00 $10,928.57 $5,328.57 0.7130 $3,799.20 6 -$18,000.00 $36,428.57 -$12,600.00 $7,000.00 $10,928.57 $5,328.57 0.6663 $3,550.65 7 -$18,000.00 $36,428.57 -$12,600.00 $7,000.00 $10,928.57 $5,328.57 0.6227 $3,318.37 8 -$18,000.00 -$12,600.00 $7,000.00 -$5,600.00 0.5820 -$3,259.25 9 -$18,000.00 -$12,600.00 $7,000.00 -$5,600.00 0.5439 -$3,046.03 10 -$18,000.00 -$12,600.00 $7,000.00 -$5,600.00 0.5083 -$2,846.76 NPV -$263,434.82 Best choice is to purchase the machinery though all the alternatives have negative NPV but its highest NPV (lowest cost), which in this case is purchasing the existing machine.

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