Calculating NPV and IRR for a Replacement A firm is considering an investment in

Question

Calculating NPV and IRR for a Replacement A firm is considering an investment in a new machine with a price of $15.6 million to replace its existing machine. The current machine has a book value of $5.4 million and a market value of $4.1 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 $6.3 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 $250,000 in net working capital. The required return on the investment is 10 percent, and the tax rate is 39 percent. What are the NPV and IRR of the decision to replace the old machine?

Explanation / Answer

Year 0 Cash Flow = -Purchase price of new machine + After tax cash flow from old machine - Initial Investment in Working Capital

Year 0 Cash Flow = -15600000 + (4100000 - 39%*(5400000-4100000)) - 250000

Year 0 Cash Flow = - 12257000

Increase in Annual Depreciation = (15600000-5400000)/4

Increase in Annual Depreciation = 2550000

Year 1 -4

Annual Operating Cash Flow = Annual Operating cost Saving*(1-tax rate) + Increase in Annual Depreciation *Tax rate

Annual Operating Cash Flow = 6300000*(1-39%) + 2550000*39%

Annual Operating Cash Flow = $ 4,837,500

Terminal Cash Flow = 250000

NPV = -Initial Investment + Annual Operating Cash FLOW*PVIFA(10%,4) + Terminal Cash Flow /(1+10%)^4

NPV = -12257000 + 4,837,500*3.169865446 + 250000/1.1^4

NPV = $ 3,247,977.46

IRR = rate(nper,pmt,pv,fv)

IRR = rate(4,4837500,-12257000,250000)

IRR = 21.64%

Decision : Since NPV is Positive the replacement is viable

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