Question

A manufacturer is considering two alternative machine replacements. Machine 1 costs $1 million with an expected life of 5-years and will generate after-tax cash flows of $350,000 a year. At the end of 5 years, the salvage value on Machine 1 is zero, but the company will be able to purchase another Machine 1 for a cost of $1.2 million. The replacement Machine 1 will generate after-tax cash flows of $375,000 a year for another 5 years. At that time its salvage value will also be zero. The manufacturer's second option is to buy Machine 2 at a cost of $1.5 million today. Machine 2 will produce after-tax cash flows of $400,000 a year for 10 years, and after 10 years it will have an after-tax salvage value of $100,000. The cost of capital for both machines is 12 percent.

- What is the NPV for both machine 1 and for machine 2?
- Which machine will have the highest NPV for the firm?
- Please explain how the selection of the machine with the highest NPV will increase the value of the firm.
- If the manufacturer chooses the machine that adds the most value to the firm, by how much will the company's value increase?

Answer #1

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