Question

A firm is considering an investment in a new machine with a price of $18.05 million to replace its existing machine. The current machine has a book value of $6.05 million and a market value of $4.55 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 $6.75 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 $255,000 in net working capital. The required return on the investment is 11 percent, and the tax rate is 34 percent. Assume the company uses straight-line depreciation. What is the NPV of the decision to purchase a new machine? What is the IRR of the decision to purchase a new machine? What is the NPV of the decision to keep the old machine?What is the IRR of the decision to keep the old machine?

Answer 1

Buy new machine:

Initial cash outflow:

Price of new machine 18.05+ Net working capital investment 0.255- market value of old machine 4.55= 13.755 mn

Cashflows for next 4 years:

Operating costs savings 6.75

Depreciation -4.5125

EBT 2.2375

Taxes -0.76075

Cash flows after tax 1.47675

NPV= -9.1725 mn

IRR= -26.935%

Keeping old machine:

Initial Cash outlfow:

Opportunity cost forgone for not selling old machine= 4.55

Cashflows for next 4 years:

Depreciation= -1.5125

Tax = 0.51425

Cashflows after tax= -0.99825

NPV= -7.64702 mn

IRR= -5.026%