Company X is tries to decide if the manually operated equipment should be replac

Question

Company X is tries to decide if the manually operated equipment should be replaced by full automatic equipment. You have the following information:

Current situation

•             Two workers with the salary 20 000 USD per year per one worker.

•             Maintenance cost is 10 000 USD per year

•             Waste (e.g. defective work) is 12 000USD per year

•             Economic lifetime of the machinery 10 years (investment was made 5 years ago)

•             Salvage value is 0. (e.g. book value in 5 years, also market value is zero)

•             Linear depreciation method (8 000 per year)

•             Current market value if sold 24 000USD

•             Tax rate 34% on EBT

New project

•             Investment (new machinery) 120 000USD

•             Two workers salary is saved

•             Maintenance cost is 15 000USD

•             Waste: 6 000USD per year

•             Economic lifetime 5 years

•             Linear depreciation method

•             Book value = market value in five years. (both book and market values are 0)

•             Required rate of return is 12%

If using excel, show formulas.

a) Prepare cash flow budget and evaluate the project based on net present value

b).Should the company replace the existing machinery?

Explanation / Answer

CALCULATION OF CASH FLOWS OF NEW PROJECT Initial cost ($120,000) Amount receivableby selling old machine $24,000 Net initial cost of replacement ($96,000) (120000-24000) Saving in workers salary per year $40,000 (20000*2) Maintenance cost ($5,000) (10000-15000) Saving in waste $6,000 (12000-6000) Economic life in years                     5 Net before tax annual savings $41,000 (40000-5000+6000) Net after tax saving per year $27,060 (41000*(1-0.34) Annual depreciation $24,000 (120000/5) Difference in depreciation $16,000 (24000-8000) Additional depreciation tax shield $5,440 (16000*0.34) After tax cash flow=27060+5440= $32,500 per year Present value(PV) of cash flow=(Cash flow)/((1+i)^N) i=discount rate=required return =12%=0.12 N=Year of cash flow N A B=A/(1.12^^=N) Year Cash flow PV of Cash flow 0 ($96,000) -96000 1 $32,500 29017.85714 2 $32,500 25908.80102 3 $32,500 23132.85805 4 $32,500 20654.33755 5 $32,500 18441.37281 TOTAL 21155.22658 NET PRESENT VALUE NPV $                21,155 b. YES , The company should replace existing machine, because NPV of investment in new machine is positive

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