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Question: Two years ago, a company purchased a machine.

Currently, the machine can be sold for Rs. 2500 hav...

Two years ago, a company purchased a machine. Currently, the machine can be sold for Rs. 2500 having a
book value of Rs. 2100. The remaining life of the machine is 6 years and is depreciated using a straight-line
depreciation method. Therefore, it records Rs. 350 per year as an annual depreciation expense. The
company may sell the machine for Rs. 500 after it completes its useful life if it is not replaced with a new
one which is technologically more advanced. A representative of high-tech manufacturing machines
approaches the company and offers to replace its old machine with a new one for Rs. 8000. This new
machine would be having Rs. 800 as an estimated scrap value at the end of its expected useful life of 6
years. The applicable depreciation rates according to 5-years MACRS class life are 20 percent, 32 percent,
19 percent, 12 percent, 11 percent and 6 percent, respectively. This new machine would help the company
increase its revenues by 1000 annually and decrees its operating expenses by 1500 annually. However, the
company would be needed to increase its inventories by Rs. 2000 as well as the accounts payables by Rs.
500. The composite WACC and marginal tax rate of the company are 11 percent and 40 percent,
respectively. Being the nancial consultant hired by the company, you are required to calculate net present
value (NPV) and internal rate of return (IRR) and suggest whether the company should replace its old
machine or not?

Expert Answer

Anusha Ganguly
answered this

Net present value: $ 1,972.47

Yes, the old machine should be replaced, as the NPV of the replacement is positive.

After tax salvage value of old machine = $ 2,500 - $ ( 2,500 - 2,100) * 0.40 = $ 2,340

Increase in net working capital = - $ 2,000 + $ 500 = - $ 1,500

Net initial investment required = - $ 8,000 - $ 1,500 + $ 2,340 = - $ 7,160

Incremental EBITDA = $ 1,000 + $ 1,500 = $ 2,500

Computation of incremental depreciation:

1 2 3 4 5 6

Depreciation $ $ $ $ $ $
of new 1,600 2,560 1,520 960 880 480
 machine

Depreciation
of old 350 350 350 350 350 350
machine

Incremental $ $ $ $ $ $
Depreciation 1,250 2,210 1,170 610 530 130

Computation of Annual Operating Cash Flows after Taxes:

Incremental annual operating cash ows after taxes = EBITDA x ( 1 - t ) + Depreciation x t

1 2 3 4 5 6

Incremental $ $ $ $ $ $
EBITDA 2,500 2,500 2,500 2,500 2,500 2,500

Incremental
1,250 2,210 1,170 610 530 130
depreciation

Operating $ $ $ $ $ $
cash ows 2,000 2,384 1,968 1,744 1,712 1,552

Computation of NPV:

0 1 2 3 4 5 6

Net initial
$(7,160)
investment

Operating
$ 2,000 $ 2,384 $ 1,968 $ 1,744 $ 1,712 1,552
cash ows

Working
capital 1,500
recovered

Incremental
salvage 300
value

Total cash $
$ 2,000 $ 2,384 $ 1,968 $ 1,744 $ 1,712 $ 3,352
ows (7,160)

PV factor at
1.0000 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346
11 %

Present
(7,160) 1,801.80 1,934.85 1,439.00 1,148.77 1,016.07 1,791.98
values

Net Present $
Value 1,972.47

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