The ABD company is considering replacing the latex molding machine it uses to fa

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

Calculation of Net Cash Outlay Purchase price of new machine (A) $775,000.00 Installation Charges (B) $25,000.00 Consultant Charges (C ) $15,000.00 Cash flow from old Machine (D) $271,800.00 Net Cash Outlay (A+B+C -D) $543,200.00 Sale Prorceeds of old Machine (A) $153,000.00 Less: Book Value $450,000.00 Capital Loss $297,000.00 Tax Shield on Loss - Loss * 40% (B) $118,800.00 Total Cash flow from old Machine (A+B) $271,800.00 Calculation of Cashflows each year 1 2 3 Increase in Sales (A) $120,000.00 $120,000.00 $120,000.00 Reduction in Cost (B) $80,000.00 $80,000.00 $80,000.00 Increase in Revenue (C = A+B) $200,000.00 $200,000.00 $200,000.00 Post Tax Cashflows (D = C*0.6) $120,000.00 $120,000.00 $120,000.00 Depreciation Rates ( E) 20% 32% 19.20% Depreciation(E = $800000*C) $160,000.00 $256,000.00 $153,600.00 Depreciation tax Shield (F = E * 0.4) $64,000.00 $102,400.00 $61,440.00 Cash Inflows (G = D+F) $184,000.00 $222,400.00 $181,440.00 Salvage Value of Machine (Note 1) (H) $0.00 0 $242,160.00 Cashflows for the years (I = G + H) $184,000.00 $222,400.00 $423,600.00 Note 1 Estimated Value of Machine (A) $250,000.00 Less: Book Value ($800000 - Cum Dep) $230,400.00 Profit $19,600.00 Taxes @40% of Profit (B) $7,840.00 Total Cash flow from Machine (A-B) $242,160.00 c. Cashflows for the years (I = G + H) $184,000.00 $222,400.00 $423,600.00 PV Factor at 12% (J) 0.8929 0.7972 0.7118 Present Value at 12% (I*J) $164,285.71 $177,295.92 $301,510.11 PV of Inflows = $643,091.75 Net Cash Outlay = $543200 NPV = $643091.75 - $543200 = $99,891.75

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