please show all the work AADR Corporation is considering the replacement of its
ID: 2654135 • Letter: P
Question
please show all the work AADR Corporation is considering the replacement of its Grounding Grinding (GG) machine. The old machine was purchased 4 years ago at an installed cost of $322,000. It is being depreciated straight-line over 7 years. It could be sold now for $149,500. The new GG machine will cost $410,000 with installation costs of $16,000. It will be depreciated straight-line over 6 years. The firm?s tax rate is 40%. Estimated annual Net Cash Benefits for the two GG machines are: 1. Calculate the initial investment (t = 0) for this replacement project. 2. Calculate the incremental cash flows for each year. 3. The company^?s cost of capital is 9%. Assuming the GG machine is of average risk, calculate the replacement project^?s Net Present Value. Is the project acceptable? Why? 4. Calculate the replacement project?s Internal Rate of Return. Is the project acceptable? Why? 5. Assume that this project^'s risk is assumed to be greater than average for the company. Calculate the replacement project?s Net Present Value based on a risk adjusted interest rate of 11%. 6. Using Internal Rate of Return, is the replacement project acceptable based on the assumption of higher risk? Why?Explanation / Answer
Replacement project for GG machine is the installation of new machine.
Cost of new GG machine = $410000
Installation cost of new GG Machine = $16000
Initial investment = Cost of new GG machine + Installation cost of new GG Machine
Initial investment = 410000+16000 = $426000
2
Annual Cash flow
Year
New Machine
Old Machine
Incremental cash flow
1
70000
51000
19000
2
70000
43000
27000
3
77000
40000
37000
4
77000
40000
37000
5
77000
40000
37000
6
77000
40000
37000
7
67000
35000
32000
8
67000
35000
32000
Incremental cash flow = Difference between yearly cash flow of new and old GG machine
3.
NPV of Replacement project = Present value of all cash inflow – initial investment
NPV of Replacement project =CF1/(1+R) + CF2/(1+R)^2 + CF3/(1+R)^3 + CF4/(1+R)^4 + CF5/(1+R)^5 + CF6/(1+R)^6 + CF7/(1+R)^7 + CF8/(1+R)^8 - 426000
R = 9%
NPV of Replacement project = 70000/1.09 + 70000/1.09^2 + 77000/1.09^3 +77000/1.09^4 +77000/1.09^5 +77000/1.09^6 +67000/1.09^7 +67000/1.09^8 - 426000
NPV of Replacement project = - $22621.72
Since, NPV of replacement project is negative. So, it cannot be accepted.
4.
As per trial & error:
At R = 8%
P.V. of Cash inflows = $418770.75
At R = 7%
P.V. of Cash inflows = $435086.27
As per the method of interpolation,
IRR =7% + ( (PV at 7% - Initial investment) / (PV at 7% - PV at 8%)) * (8% - 7%)
IRR =7% +((435086.27- 426000) / (435086.27-418770.75)) *1%
IRR = 7.55%
Since IRR is less than the minimum required rate of return 9% (cost of capital). So, project cannot be accepted. It needs to be rejected.
5.
R = 11%
NPV of Replacement project = 70000/1.11 + 70000/1.11^2 + 77000/1.11^3 +77000/1.11^4 +77000/1.11^5 +77000/1.11^6 +67000/1.11^7 +67000/1.11^8 - 426000
NPV of Replacement project = - $50892.059
6.
IRR of replacement project is already calculated in Q. 4 and it does not change with perceived high risk. At this IRR of 7.55%, it is very less than the Adjusted require rate of return of 11%. So, it will be rejected.
Annual Cash flow
Year
New Machine
Old Machine
Incremental cash flow
1
70000
51000
19000
2
70000
43000
27000
3
77000
40000
37000
4
77000
40000
37000
5
77000
40000
37000
6
77000
40000
37000
7
67000
35000
32000
8
67000
35000
32000
Incremental cash flow = Difference between yearly cash flow of new and old GG machine
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