Company X\'s management is evaluating a piece of machinery that costs S1 million

Question

Company X's management is evaluating a piece of machinery that costs S1 million. This machine will replace an existing machine that could be sold today for $300,000. The old machine could continue operating for another ten years. The machine has current value of S200.000 and is being deprecated at a rate of S50,000 per year (i.e. it will be depreciated for another four years). The new machine has the same production capacity as the old machine, but operating costs will be lower each year by S200,000. The new machine will require an additional S50,000 in increased working capital for its operations. The new machine is expected to have a life of ten years. It is to be depreciated to a zero book value over ten years using the straight-line method. However, at the end of ten years it is expected to have a salvage value of S100,000. Company X is profitable and expects to continue paying taxes at 35%. Given the risk involved in this project, investors expect a return of 15% Answer the following questions: a. What is the time-zero cash flow of the replacement decision? b. What is the recurring annual cash flow, for years l through 4, of the replacement decision? c. What is the recurring annual cash flow, for years 5 through 10, of the replacement decision? This does not include salvage and working capital cffects. d. What is the end-period (year 100 cash flow effect of the replacement decision? This is in addition to the year 10 cash flow in part (b). e. What is the NPV of replacing the old machine with the new one?

Explanation / Answer

a What is the time zero cash flow of the replacement decisison? Cost of new machine $1,000,000.00 Less: Proceeds from sale of existing machinary $300,000.00 Add: Tax on solvage ($300,000-$200,000)*35% $35,000.00 add: Increased working capital $50,000.00 The time zero cash flow of the replacement decisison $785,000.00 b Recurring cash flows from the replacement 1-4 years Savings in opertaing cost $200,000.00 Less: Depreciataionof new ($100,000.00) Add: Depreciation of existing $50,000.00 EBIT $150,000.00 Less: Tax (35%) $52,500.00 EAT $97,500.00 Add: Depreciataionof new $100,000.00 Less: Depreciation of existing $50,000.00 Net Cash flows for 1 to 4 years $147,500.00 c Recurring cash flows from the replacement 5-10 years EAT $97,500.00 Add: Depreciataionof new $100,000.00 Net Cash flows for 5 to 10 years $197,500.00 d Working capital gain net of tax ($50000*0.65) $32,500.00 e NPV Year Cash flows PV factor@15% PV of cash flows 1 ($785,000.00) 1 ($785,000.00) 2 $147,500.00 0.869565217 $128,260.87 3 $147,500.00 0.756143667 $111,531.19 4 $147,500.00 0.657516232 $96,983.64 5 $197,500.00 0.571753246 $112,921.27 6 $197,500.00 0.497176735 $98,192.41 7 $197,500.00 0.432327596 $85,384.70 8 $197,500.00 0.37593704 $74,247.57 9 $197,500.00 0.326901774 $64,563.10 10 $230,000.00 0.284262412 $65,380.35 NPV of the project $52,465.10 a ($785,000.00) b $147,500.00 c $197,500.00 d $230,000.00 e $52,465.10

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