The ABD company is considering replacing the latex molding machine it uses to fa
ID: 2758798 • Letter: T
Question
The ABD company is considering replacing the latex molding machine it uses to fabricate rubber boots with a newer, more efficient model. The old machine has a book value of $450,000 and a remaining useful life of 5 years. ABD can sell it now to another firm for $153,000. The old machine is being depreciated on a straight line basis over the next 5 years to a zero salvage value. If used for three more years, it should sell for $50,000. The new machine has a purchase price of $775,000. An additional $25,000 would be spent in shipping and installation. The machine is expected to have a market value of $250,000 in three years. In addition, a consultant was paid $15,000 to estimate the cost benefit, future market value, and identify the best manufacturer of this replacement machine. The machine is classified as a 5 year class MACRS asset for depreciation purposes. The applicable depreciation rates are: 20%, 32%, 19.2%, 11.52%, 11.52% and 5.76% respectively. The new machine is not only more efficient, requiring less electricity, labor and repair costs, reducing expenses by $80,000 per year, but most important it can produce different colored boots that are expected to increase sales by $120,000 a year. This project is expected to last only 3 more years. The firm’s marginal tax rate is 40% and its WACC is 12%. Two other coworkers have already calculated the NPVs for the other ‘states of nature’ (scenarios). Scenario A has a 40% chance of occurring and a NPV of $50,000. Scenario B has a 25% chance of occurring and has a NPV of $75,000. You are calculating Scenario C and justifying the final decision to accept or reject this investment project FIND: 1/ Net cash outlay 2/ Cash flow of year 1,2,3 3/ Calculate the NPV of this SCENARIO: 4/ Should the firm accept or reject this investment (why).
Explanation / Answer
Answer:
1. Net Cash Outflow if the new machine is purchased now:
Purchase Price = $ 775,000
Shiping and transportation Cost = $ 25,000
Consultant Fees = $ 15,000
Total Cost of New Machine = $ 815,000
Less: Sale Value of Old Machine = $ 153,000
Net Initial Cash Outlay = $ 662,000
2. Incremental Cash Flows for Year 1, 2 and 3 when new machine is purchased now and used for 3 years:
Note: For calculating incremental depreciation we have considered Cost of New Machine as $ 815,000 and incremental depreciation is deprediation of new machine minus $ 90,000 (depreciation of old machine if the same would have been used for 3 more years)
Similarly for realisable value of new machine after 3 years we have taken incremental realisable value.
3. Net Present Value of the Scenario at 12% WACC is as under:
Present Value of Cash Outflow = $ 662,000
Present Value of Cash Inflows = Above Annual Cash Inflows x Present Value Factors for corresponding years at 12% = $ 530,039
NPV = % 530,039 - $ 662,000 = - $ 131,961
4. Since the NPV is negative the new machine should not be purchased.
Year Initial Cash Outflow Saving in Expense Incremental Sales Incremental Depreciation Corporate Tax Total Incremental Cash Flow 0 (662,000) Nil Nil Nil Nil (662,000) 1 Nil 80,000 120,000 73,000 [(200,000 - 73,000)*40%] 50,800 (200,000 - 73,000 - 50,800 + 73,000) 149,200 2 Nil 80,000 120,000 170,800 11,680 188,320 3 (250,000 - 50,000) 200,000 80,000 120,000 66,480 53,408 346,592Related Questions
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