Question

] Burton, a manufacturer of snowboards, is considering replacing an existing piece of equipment with a more sophisticated machine. The following information is given. • The proposed machine will cost $120,000 and have installation costs of $20,000. It will be depreciated using a 3 year MACRS recovery schedule. It can be sold for $60,000 after three years of use (before tax; at the end of year 3). • The existing machine was purchased two years ago for $95,000 (including installation). It is being depreciated using a 3 year MACRS recovery schedule. It can be sold today for $20,000. It can be used for three more years, but after three more years it will have no market value. • The earnings before taxes and depreciation (EBITDA) are as follows: o New machine: Year 1: 133,000, Year 2: 96,000, Year 3: 127,000 o Existing machine: Year 1: 84,000, Year 2: 70,000, Year 3: 74,000 • Burton pays 40 percent taxes on ordinary income and capital gains, and uses a WACC of 14%. • The maximum payback period allowed is 3 years. • They expect a large increase in sales so their Net Working Capital will increase by $20,000 when they buy the machine and it will be recovered at the end of the project life. a. Calculate the initial investment required for this project. b. Determine the incremental after-tax operating cash flows c. Find the terminal cash flow for the project d. Find the Discounted Payback period, NPV, IRR, and MIRR. e. Should the new machine be purchased? Why or why not?

Answer 1

Answer a:

Old machine:

Old machine book value now = $21,109

Sale value = $20,000

Sale value net of tax = 20000 + (21109 - 20000) * 40%

= $20,443.60

Initial investment required = New Machine cost + Installation cost - Sale value of old machine net of tax + Increase in working capital

= $120,000.00 + $20,000.00 - $20,443.60 + $20,000.00

= $139,556.40

Initial investment required = $139,556.40

Answer b:

Answer c:

Answer d:

Answer e:

The machine should not be purchased.

The replacement decision is rejected by all evaluation criteria.

NPV is negative

Discounted payback period is more than 3 years (project life)

IRR < Cost of capital

MIRR < Cost of capital