A firm is considering an investment in a new machine with a price of $18.15 mill

Question

A firm is considering an investment in a new machine with a price of $18.15 million to replace its existing machine. The current machine has a book value of $6.15 million and a market value of $4.65 million. The new machine is expected to have a four-year life, and the old machine has four years left in which it can be used. If the firm replaces the old machine with the new machine, it expects to save $6.85 million in operating costs each year over the next four years. Both machines will have no salvage value in four years. If the firm purchases the new machine, it will also need an investment of $265,000 in net working capital. The required return on the investment is 12 percent, and the tax rate is 35 percent. Assume the company uses straight-line depreciation. What is the NPV of the decision to purchase a new machine? What is the IRR of the decision to purchase a new machine? What is the NPV of the decision to keep the old machine? What is the IRR of the decision to keep the old machine?

Explanation / Answer

NPV of purchasing new machine = $13.71 Million

IRR of purchasing new machine 53.8% (Excel formula has been used)

The NPV of the decision to keep the old machine = $0.02 Million

The IRR of the decision to keep the old machine = 12.2%

$ Mn Price of new machine 18.15 Life , years 4 Depreciation p.a. 4.5375 Incremental saving in operating cost 6.85 Less: tax 2.3975 Net Saving 4.4525 Add: Depreciation 4.5375 Operating Cash flow from new machine 8.99 Initial Cash Out Flow Cost of New Machine 18.15 Less Sale of Old machine 4.65 Net Cost 13.5 Add Investment in Net Working Capital 0.265 Total outflow at year 0 13.765 It is assumed that NWC will be free at year 4 and inflow would be 0.265

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