Strong Structures Inc. is considering the replacement of an existing machine. Th
ID: 2594157 • Letter: S
Question
Strong Structures Inc. is considering the replacement of an existing machine. The new machine costs $1,300,000 and requires installation costs of $100,000. The existing machine currently has a salvage value of $210,000 before taxes. It was purchased at a price of $1,000,000 (also its depreciable base) and has been depreciated under the MACRS 5-year recovery period. Over the 7-year economic life of the replacement proposal, the new machine should reduce operating costs by $450,000 per year. The new machine will be depreciated under the MACRS 5-year recovery period and can be sold for $180,000 at the end of its economic life. Also, the new machine will require an increase in net working capital of $40,000. The WACC is 12% and marginal tax rate is 40%.
a. What is the Net Initial Investment on the project?
b. What are the NCFs?
c. What is the Terminal Value?
d. What is the NPV, IRR and payback period of the proposed project? Make a recommendation on the project based on these results.
Explanation / Answer
INITIAL INVESTMENT: Cost of the new machine 1300000 Cost of installation 100000 Total cost of the new machine 1400000 Increase in NWC 40000 After tax salvage value of the old machine = 210000*(1-0.40) = -126000 NET INITIAL INVESTMENT ON THE PROJECT 1314000 NOTE: The age of the old machine is not given though it is said that MACRS depreciation has been applied. Hence, it is presumed that the old machine has been fully written off and that the book value is '0'. NET CASH FLOWS: 1 2 3 4 5 6 7 Pretax savings in operating costs 450000 450000 450000 450000 450000 450000 450000 Depreciation on new machinery (5 Year MACRS) 280000 448000 268800 161280 161280 80640 0 Incremental pre tax net income 170000 2000 181200 288720 288720 369360 450000 Tax at 40% 68000 800 72480 115488 115488 147744 180000 Incremental NOPAT 102000 1200 108720 173232 173232 221616 270000 Add: Depreciation 280000 448000 268800 161280 161280 80640 0 OCF 382000 449200 377520 334512 334512 302256 270000 TERMINAL VALUE (NET CASH FLOWS) After tax salvage value of the new machine = 180000*(1-0.40) = 108000 Recovery of NWC 40000 Terminal value 148000 CALCULATION OF NPV: Net cash flows 382000 449200 377520 334512 334512 302256 270000 PVIF at 12% 0.89286 0.79719 0.71178 0.63552 0.56743 0.50663 0.45235 PV at 12% 341071 358099 268711 212588 189811 153132 122134 Sum of PVs of NCF of years 1 to 7 1645548 PV of terminal value = 148000*0.45235 = 66948 PV of cash inflows 1712496 Less: Initial investment 1314000 NPV $ 398,496 Answer CALCULATION OF IRR: IRR is that discount rate for which NPV = 0. It has to be found out by trial and error. Total PV NPV Yearly NCF 382000 449200 377520 334512 334512 302256 270000 Terminal value 148000 Annual after tax cash flows 382000 449200 377520 334512 334512 302256 418000 PVIF at 20% 0.83333 0.69444 0.57870 0.48225 0.40188 0.33490 0.27908 PV at 20% 318333 311944 218472 161319 134433 101225 116656 1362383 48383 PVIF at 21% 0.82645 0.68301 0.56447 0.46651 0.38554 0.31863 0.26333 PV at 21% 315702 306810 213100 156052 128969 96308 110072 1327014 13014 PVIF at 22% 0.81967 0.67186 0.55071 0.45140 0.37000 0.30328 0.24859 PV at 22% 313115 301801 207903 150998 123769 91668 103910 1293163 -20837 IRR lies between 21% and 22%. By simple interplation, IRR = 21+13014/(13014+20837) = 21.38% Answer PAYBACK: Annual after tax cash flows 382000 449200 377520 334512 334512 302256 418000 Cumulative cash flows 382000 831200 1208720 1543232 1877744 2180000 2598000 Payback = 3+(1314000-1208720)/334512 = 3.31 Years. RECOMMENDATION: As the NPV is positive (because of which IRR is >WACC), the replacement can be made.