Two years ago the Krusty Krab Restaurant purchased a grill for $50,000. The owne

ID: 2771929 • Letter: T

Question

Two years ago the Krusty Krab Restaurant purchased a grill for $50,000. The owner, Eugene Krabs, has learned that a new grill is available that will cook Krabby Patties twice as fast as the existing grill. This new grill can be purchased for $80,000 and would be depreciated straight line over 8 years, after which it would have no salvage value. Eugene Krab expects that the new grill will produce EBITDA of $50,000 per year for the next eight years while the existing grill produces EBITDA of only $35,000 per year. The current grill is being depreciated straight line over its useful life of 10 years after which it will have no salvage value. All other operating expenses are identical for both grills. The existing grill can be sold to another restaurant now for $30,000. The Krusty Krab's tax rate is 35%.

If the Krusty Krab's opportunity cost of capital is 12%, then the NPV for upgrading to the new grill is closest to

Explanation / Answer

NPV = Present value of Cash inflow (A) - Present value of Cash outflow (B) = $ 16366

(B) = 80000 (Purchase cost of new machine)

(A) = Present value of cash inflow

= 30000 ( Existing grill sold immediately ) + 66366 ( See working note)

= 96366

NPV = 96366 - 80000 = $ 16366

Working note

Additional EBITDA

(-) Additional depreciation

15000 (50000 – 35000)

3000 (80000 – 50000 /3)

Additional Earning before tax

(-) Tax @35 %

12000

4200

Earnings after tax

(+) Depreciation

7800

3000

Free Cash Flows

10800

Cumulative Present value factor @ 10 % for 10 Years = 6.145

So, Total Present value of cash inflows = 10800 * 6.145 = 66366