Andrusco Corp\'s new vice president of Finance, Mr Rufus, has discovered that a
ID: 2648055 • Letter: A
Question
Andrusco Corp's new vice president of Finance, Mr Rufus, has discovered that a production machine authorized for purcahse last year y his fired predecessor Mr. Miranda, is not functionng well on the production floor. Therefore he has decided and recieved approval to replace this machine with a new one. The new machine will cost 50,000, has a 5 year economic life, will use DDB depreciation, and a residual value of 5,000$. The old machine was using SYD depcration with a 5 year life with 2000$ salvage value and originally cost 40,000. The old macine can be sold in todays market for 30,000. The US president has wisely reinstituted the Investment Tax Credit for corporations that had been outlawed. New unadjusted cash flows from the new equipment will be 20,000; 10,000; 10,000; 10,000; and 15,000. Maintenence cost will be 1000 in both years 2 and 4. A commercial crane will have to be hired to place the new equipment on t he shop floor to the tune of 2500. This is incremental analysis. Preferred stock is sold at 39.875 with a par of 1$. Last dividend was 3.5 cents per share. What is the NPV
Explanation / Answer
Dividend declared in dollars =0.035
Cost of capital = dividend/market value = 0.035/39.875 =0.0878% there fore required return on the investment = 0.0878%.
Depreciation of old machine using straight line method =($40,000 - $2000)/5 =$7,600 per year for 5 years.
Depreciation of the new machine is done on double declining balance method:
straight line depreciation rate =1/5 =.20 or 20%
Double declining rate =2*20% =40%
In the 5th year depreciation is limited to $1,480 because, if depreciation is calculated at 40%of 6,480, it comes to $2,592 and book value after depreciation = $6,480 - $2,592.=$3,888. As the book value after depreciation is less than the salvage value, depreciation should be limited to $6,480 - $5,000 = $1,480.
Let us assume an investment tax credit of 20% and an effetive tax rate applicable to the corporate = 32%
Cash outflow in Year 0 =Cash outflow on account of purchase - sale price of old machine + installation cost.
=$50,000 -$30,000+$2,500 = $22,500.- tax savings on account of investment 20%*$50,000
$22,500 - $10,000
Net cash outlfow =$12,500
Cash flows for the five years as follows:
Present value of cash flows is as below:
In year 5 the machine salvage value is $5,000., hence it is also considered as inflow in year 5.
As the NPV is more than zero, the replacement decision should be taken up.
Year Depreciation Book value 1 $20,000.00 $30,000.00 2 $12,000.00 $18,000.00 3 $7,200.00 $10,800.00 4 $4,320.00 $6,480.00 5 $1,480.00 $5,000.00