8. Kim is a divisional manager who plans to retire in a year. Her bonus is based on the net income of her division. Kim has an expensive piece of machinery that is vital to her division’s production efforts. The problem is that this machinery has been breaking down frequently over the past year. Kim has to decide whether to (i) replace the machinery at a cost of $5 million (the life of the new machine is expected to be 10 years with a salvage value of $1 million and depreciation will be straight line), (ii) keep repairing it fof $325,000 a year. (a) Discuss which option would be in Kim’s best interest and why, (b) Discuss which option would be in the stockholders’ best interest and why.
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Cost of new machine | 5,000,000.00 | ||||||||||
| Cost saving | 325,000.00 | 325,000.00 | 325,000.00 | 325,000.00 | 325,000.00 | 325,000.00 | 325,000.00 | 325,000.00 | 325,000.00 | 325,000.00 | |
| Depreciation | 500000 | 500000 | 500000 | 500000 | 500000 | 500000 | 500000 | 500000 | 500000 | 500000 | |
| salvage value | 1,000,000.00 | ||||||||||
| Cash flow before tax | -5,000,000.00 | -175,000.00 | -175,000.00 | -175,000.00 | -175,000.00 | -175,000.00 | -175,000.00 | -175,000.00 | -175,000.00 | -175,000.00 | 825,000.00 |
| Tax | -61250 | -61250 | -61250 | -61250 | -61250 | -61250 | -61250 | -61250 | -61250 | 288750 | |
| Net cash flow | -5,000,000 | 386,250.00 | 386,250.00 | 386,250.00 | 386,250.00 | 386,250.00 | 386,250.00 | 386,250.00 | 386,250.00 | 386,250.00 | 1,036,250.00 |
| IRR | -1.63% | ||||||||||
| Since we have negetive IRR we should not buy the new machine rather continue with the old one | |||||||||||
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