Question

International Automotive (IA) Company is a manufacturer and distributor of large assembly machinery

for the automotive industry. The firm’s customers include seven of the top ten auto makers (by total

annual units) in the world. The auto makers are continually searching for more advanced technological

solutions to cut long-term costs and increase efficiency. One such company, U.S. Automotive (USA) Inc.,

has been in discussions with IA about replacing one of its welding robots with a more advanced model.

IA’s sales manager has proposed two cash purchase alternatives for USA’s consideration. Both would

speed up welding times and reduce labor costs since fewer change-overs and maintenance would be

required. Key financial data for the old robot and the two proposed alternatives are summarized below.

Old robot: Originally purchased 3 years ago at an installed cost of 425,000, it is being

depreciated under the MACRS 5-year schedule. It’s remaining economic life is 5 years.

The robot can be sold now for $445,000 before taxes. If retained instead, it can be sold

at the end of 5 years to net $160,000 before taxes.

Robot X: The more advanced of the two recommended alternatives, it can be purchased

for $790,000 and will require $30,000 of installation costs. The 5-year MACRS depreciation

schedule will be used. At the end of 5 years it’s estimated the machine could be sold to net

$380,000 before taxes. Current account changes associated with the acquisition of this

robot are listed in the table below.

Cash	$20,000
Accounts receivable	$100,000
Inventory	$ (22,600)
Accounts payable	$31,00

Robot Y: Purchase cost is $600,000 and installation cost is $25,000. The same 5-year MACRS

depreciation schedule will be used. At the end of 5 years, the robot can be sold to net $290,000

before taxes. No effect on the firm’s current accounts is expected.

Estimated earnings before depreciation and taxes for each of the three robots (old, X and Y) over the

next 5 years is shown in the table below. USA is subject to a corporate tax rate of 21% and cost of capital

of 13%.

EBDT for U.S. Automotive Inc. robot scenarios:

Year	Old Robot ($)	Robot X ($)	Robot Y ($)
1	115K	240K	199K
2	115K	280K	199K
3	115K	290K	199K
4	115K	320K	199K
5	115K	340K	199K

Questions:

1) For each of the two proposed replacement robots, calculate:

A. Initial investment

B. Operating cash inflows and Incremental cash inflows

C. Terminal cash flow

2) Based on the data from question #1, depict in both table and timeline format the relevant cash

flow stream for Robot X and Robot Y, assuming each is terminated at the end of year 5.

3) Calculate for the new robot alternatives each of the following decision methods.

A. Payback period

B. NPV

C. IRR

4) Recommend which, if either, of the new robots USA should acquire if the firm has

A. unlimited funds

B. capital rationing

5) Assuming the cash inflows associated with Robot X are considered significantly riskier than

Robot Y, how does this impact your recommendation in question #4?

Answer 1

A. Initial Investment	Robot X	Robot Y
(790000+30000)	-820000
(600000+25000)		-625000
Changes to net wkg. Capital	-128400	0
Total	-948400	-625000

B.Operating cash inflows:
Year	0	1	2	3	4	5
Robot X
1.EBDT		240000	280000	290000	320000	340000
2.MACRS depn.		-164000	-262400	-157440	-94464	-94464
3.EBT(1+2)		76000	17600	132560	225536	245536
4.Tax at 21%(Row.3*21%)		-15960	-3696	-27838	-47363	-51563
5.EAT(3+4)		60040	13904	104722	178173	193973
6.Add back: Depn.(Row.2)		164000	262400	157440	94464	94464
7.Operating Cash inflow(5+6)		224040	276304	262162	272637	288437
Year	0	1	2	3	4	5
Robot Y
1.EBDT		199000	199000	199000	199000	199000
2.MACRS depn.		-125000	-200000	-120000	-72000	-72000
3.EBT(1+2)		74000	-1000	79000	127000	127000
4.Tax at 21%(Row.3*21%)		-15540	210	-16590	-26670	-26670
5.EAT(3+4)		58460	-790	62410	100330	100330
6.Add back: Depn.(Row.2)		125000	200000	120000	72000	72000
7.Operating Cash inflow(5+6)		183460	199210	182410	172330	172330
Incremental opg. Cash inflow(X-Y)-----------(X7-Y7)		40580	77094	79752	100307	116107

MACRS depreciation workings:
Initial Inv.	820000	625000
Year	Robot X	Robot Y
1	164000	125000
2	262400	200000
3	157440	120000
4	94464	72000
5	94464	72000
Acc. Depn.	772768	589000
Book value at end of Yr. 5	47232	36000

C. Terminal cash flows
1.Cost	820000	625000
2.Acc. Depn.(as above)	772768	589000
3.Book value (1-2)	47232	36000
4.Before-tax salvage(Given)	380000	290000
5.Gain on salvage(4-3)	332768	254000
6.Tax on gain at 21% (Row 5*21%)	69881	53340
7.After-tax cash flow on salvage(4-6)	310119	236660
8.NWC restored	128400	0
Total terminal cash flows	438519	236660

2 & 3.Relevant cash flows/PB/NPV/IRR
Robot X
A. Initial Investment	-948400
B.Operating Cash inflow		224040	276304	262162	272637	288437
C.Terminal cash flows						438519
D.Total annual cash flows(A+B+C)	-948400	224040	276304	262162	272637	726956
a.Payback period:
Cumulative cash flows	-948400	-724360	-448056	-185894	86744	813700
Payback period=3+(185894/272637)
3.68 Years
b. NPV
E.PV F at 13%	1	0.88496	0.78315	0.69305	0.61332	0.54276
F.PV at 13%(D*E)	-948400	198265	216387	181692	167214	394563
NPV (sum of row F)	209720
IRR (of Row D)	20%
Robot Y
A. Initial Investment	-625000
B.Operating Cash inflow		183460	199210	182410	172330	172330
C.Terminal cash flows						236660
D.Total annual cash flows(A+B+C)	-625000	183460	199210	182410	172330	408990
a.Payback period:
Cumulative cash flows	-625000	-441540	-242330	-59920	112410	521400
Payback period=3+(59920/172330)
3.35 Years
b. NPV
E.PV F at 13%	1	0.88496	0.78315	0.69305	0.61332	0.54276
F.PV at 13%(D*E)	-625000	162354	156011	126419	105693	221983
NPV (sum of row F)	147461
IRR (of Row D)	21%

4. Recommendation:

A. If unlimited funds: both are recommended-- as both give POSITIVE NPVs & IRR > COC 13% & almost same Pay back periods

B.Capital rationing: Robot X as it returns greater NPV ,ie.209720 > 147461

5) Assuming the cash inflows associated with Robot X are considered significantly riskier than

Robot Y,

Robot Y will be preferred as it returns POSITIVE NPV & greater IRR than COC(21%>13%) & also less riskier than Robot X