Beryl’s Iced Tea currently rents a bottling machine for $53,000 per year, includ

Question

Beryl’s Iced Tea currently rents a bottling machine for $53,000 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 $160,000. This machine will require $22,000 per year in ongoing maintenance expenses.

B.) Purchase a new, more advanced machine for $265,000. This machine will require $16,000 per year in ongoing maintenance expenses and will lower bottling costs by $13,000 per year. Also, $40,000 will be spent upfront in training the new operators of the machine.

Suppose the appropriate discount rate is 8% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each year, as is the rental of the 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 35%. 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 with each alternative.

Explanation / Answer

Continue renting the existing machine:

After tax cash outflow on account of rent per year = 53000*(1-0.35) = 34450

PV of the cash outflows = 34450*pvifa(8,10) = 34450*6.7101 = $231,163

Purchase the exising machine:

PV of the after tax yearly maintenance expenses = 22000*0.65*6.7101 = $95,954

PV of tax shield on depreciation for seven years = (160000/7)*0.35*pvifa(8,7) = 22857*0.35*5.2064= $41,651

NPV = 160000 + 95954 - 41651 = $214,303.

Purchase the new, more advanced machine:

PV of the after tax yearly net maintenance expenses (after savings in bottling costs) = 3000*0.65*6.7101 = $13,085

PV of tax shield on depreciation for seven years = (265000/7)*0.35*pvifa(8,7) = 37857*0.35*5.2064= $68,985

PV of tax shield on training cost payable upfront = 40000*0.35/1.08 = $12,963

NPV = 265000 + 40000 + 13085 - 68965 - 12963 = $236,157

Decision:

Of the three alternatives, the Alternative A - Purchasing the existing rented machine for $160000, is the best alternative as it has the lowest PV of cash outflows.

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