A firm is considering an investment in a new machine with a price of $18.05 mill

ID: 2777245 • Letter: A

Question

A firm is considering an investment in a new machine with a price of $18.05 million to replace its existing machine. The current machine has a book value of $6.05 million and a market value of $4.55 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 $6.75 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 $255,000 in net working capital. The required return on the investment is 11 percent, and the tax rate is 34 percent. Assume the company uses straight-line depreciation.

What is the NPV of the decision to purchase a new machine? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16). Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

What is the IRR of the decision to purchase a new machine? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16))

What is the NPV of the decision to purchase the old machine? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16). Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Negative amount should be indicated by a minus sign.)

What is the IRR of the decision to purchase the old machine? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16). Negative amount should be indicated by a minus sign.)

Explanation / Answer

Requirement 1: a. and b.

Assuming that additional investment in Net workings capital is done immediately after purchasing new machine

Cash flow in Year 0:

-18.05 - 0.255 = -18.31

Company gets depreciation tax shield on capital loss on selling old machine as follows

= 0.34 ( 6.05 - 4.55) = 0.51

Net cash flow in year 0 = -18.31 + 0.51 = -17.80

Cash flow in Year 1, 2, 3 & 4:

Decrease in operating costs, increases cash flows, which has tax effects,

so cash flow impact = 6.75 * (1-34%) = 4.46

Since new machine is depreciated using staight line depreciation method, machine is depreciated by 18.05 / 4 = 4.51 each year. This amount gets a depreciation tax shield, which is equal to = 4.51 * 34% = 1.53

Net Cash flows in Year 1, 2, 3 & 4 = 4.46 + 1.53 = 5.99

Now calculate NPV using the formula = NPV(11%,A1:A5) = 0.71 million

So dollor number would be $ 708,398.96

IRR can be calculated as =IRR(A1:A5) = 13.05%

Requirement 2: a. and b.

Cash flow in Year 0 = -4.55

Cash flow in Year 1, 2, 3 & 4:

Since old machine is depreciated using staight line depreciation method, machine is depreciated by 4.55 / 4 = 1.14 each year. This amount gets a depreciation tax shield, which is equal to = 1.44 * 34% = 0.39

Net Cash flows in Year 1, 2, 3 & 4 = 0.39

Now calculate NPV using the formula = NPV(11%,A1:A5) = -3.02 million

So dollor number would be - $ 3,018,134.35

IRR can be calculated as =IRR(A1:A5) = -32.54%

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