Question

A firm is considering an investment in a new machine with a price of $18 million to replace its existing machine. The current machine has a book value of $6 million and a market value of $4.5 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 $6.7 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 rate of 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?

Answer 1

Net Present value Calculation of cash outflow at Year 0 Book value of $60,00,000.00 Current machine Sale Price of $45,00,000.00 Current machine Loss on sale $15,00,000.00 Tax save on loss $5,85,000.00 Net cash inflow $50,85,000.00 New machine cost $1,80,00,000.00 Net cash outflow $1,29,15,000.00 Calculation of cash inflow after tax Saving in cost Tax @39% Year $67,00,000.00 $67,00,000.00 $67,00,000.00 $67,00,000.00 $26,13,000.00 $26,13,000.00 $26,13,000.00 $26,13,000.00 Cash inflows net of tax $40,87,000.00 $40,87,000.00 $40,87,000.00 $40,87,000.00 Net Present value Year Cash Outflow Cash inflow Working capital -$1,29,15,000.00 $0.00 $0.00 $0.00 $0.00 $0.00 $40,87,000.00 $40,87,000.00 $40,87,000.00 $40,87,000.00 -$2,50,000.00 $0.00 $0.00 $0.00 $0.00 Release of Net cash flows working capital $0.00 $1,31,65,000.00 $0.00 $40,87,000.00 $0.00 $40,87,000.00 $0.00 $40,87,000.00 $2,50,000.00 $43,37,000.00 Net Present value Present value Present value of factor @10% cash flows $1.00 $1,31,65,000.00 $0.91 $37,15,083.00 $0.83 $33,75,862.00 $0.75 $30,69,337.00 $0.68 $29,62,171.00 -$42,547.00

Internal rate of return Year Cash Outflow Cash inflow Working capital Net cash flows $1,29,15,000.00 $0.00 $0.00 $0.00 $0.00 $0.00 $40,87,000.00 $40,87,000.00 $40,87,000.00 $40,87,000.00 $2,50,000.00 $0.00 $0.00 $0.00 $0.00 Release of working capital $0.00 $0.00 $0.00 $0.00 $2,50,000.00 IRR $1,31,65,000.00 $40,87,000.00 $40,87,000.00 $40,87,000.00 $43,37,000.00 9.86% Decision- As the NPV is negative and IRR is less than the required rate of return on investment the machine should not be replaced

E F G 1 Net Present value 2 Calculation of cash outflow at Year o 3 Book value of 4 Current machine 6000000 5 Sale Price of 6 Current machine =4.5*1000000 7 Loss on sale =B3-B5 8 Tax save on loss =B7*39% 9 Net cash inflow !=B8+85 10 New machine cost 18000000 11 Net cash outflow =B10-B9 13 14 Calculation of cash inflow after tax Saving in cost Tax @39% Year 16 1 17 2 18 3 19 4 =6.7*1000000 =B1639% =6.7*1000000 =B17*39% =6.7. 1000000 =B18.39% =6.7 1000000 =B19*39% Cash inflows net of tax =B16-C16 =B17-C17 =B18-C18 =B19-C19 21 Net Present value Year Cash Outflow C ash inflow 23 -12915000 24 O 25 1 26 2 4087000 4087000 4087000 4087000 Working capital Release of Net cash flows Present value Present value Yorking factor @10% of cash flows -250000 0 =SUM(B24:E24) 1 =G24-F24 0 =SUM(B25:E25) 0.909 =G25*F25 =SUM(B26:E26) 0.826 =G26*F26 0 =SUM(B27:E27) 0.751 =G27*F27 0 250000 =SUM(B28:E28) 0.683 =G28*F28 Net Present value =SUM(H24:H28) 27 3 28 4

E 34 36 Internal rate of return Cash Outflow Year Cash inflow Working capital 38 390 40 -129150000 -250000 4087000 4087000 4087000 4087000 Release of Net cash flows Yorking capital 0 =SUM(B39:E39) =SUM(B40:540) =SUM(B41:E41) =SUM(B42:E42) 250000 =SUM(B43:E43) IRR IRR(F39:F43) 0 48 Decision- 49 As the NPV is negative and IRR is less than the required rate of return on investment the machine should not be replaced 51 50