Please explain each step. Pintail Products, Inc. (PPI) is negotiating for the pu
ID: 2716511 • Letter: P
Question
Please explain each step.
Pintail Products, Inc. (PPI) is negotiating for the purchase of a new piece of equipment for its current operations. PPI has a bid which specifies that the equipment could be purchased for $80,000. Other information about the project includes the following: The new equipment will replace existing equipment that has a current market (i.e., resale) value of $20,000. If the new equipment is purchased, the old equipment will be sold. The old equipment was purchased for $40,000 and is being depreciated on a straight-line basis over ten years. It is expected to last another eight years and to have no resale value at the end of eight years. It is currently five years old. The new equipment is expected to have a positive effect on revenue. Revenues are expected to increase by $2,000 the first year, by $3,000 the second year, and by $4,000 the third year and following years for the duration of the project. Additionally, before-tax operating costs will be reduced by $11,000 per year for eight years. The revenues and cost savings will occur at year-end. The increased sales will give rise to an aggregate increase in accounts receivable, inventory, and cash, equal in total to 25% of the increase in sales. The increase in current asset occurs at the beginning of each year. Additionally, trade credit (i.e., accounts payable) will increase by an amount equal to 10% of the increase in sales. The increase in accounts payable occurs at the beginning of each year. The initial increase in receivables, inventory, cash, and payables will occur at time 0 (i.e., they are needed to get the project started). This investment in working capital will be recovered at the end of the project’s life. The new equipment will be depreciated to zero using straight-line depreciation over eight years. PPI expects to discontinue this project, and sell the equipment of $5,000 at the end of eight years. The gain from the proceeds of the sale is subject to the ordinary income tax rate of 35%. The after-tax nominal cost of capital for this project is 12% per year.
What is the NPV of replacing the old machine with the new one?
Explanation / Answer
Price of new machine 80,000 resalve value of old machine 20,000 Price of old machine 40,000 Dep at SLM for 10 yrs currently 5 yrs old new machine life 8 yrs salvage new machine 5,000 income tax 35% cost of capital 12% Depreciation for new machine= (80000-5000)/8 $9,375 Dep for old machine $4,000 incremental Depreciation $5,375 Tax saving on inc. depreciation (5375*.35) $1,881.00 Initial capital outlays: bookvalue of old machine 40000-(4000*5) $20,000 after tax salvage value: 20000-0.35*(20000-20000) $20,000 new machine cost is 80000 80000-20000 $60,000 1 2 3= (1+2)*(1-.35) 4 5=3+4 6 7=6*5 year inceremental revenue reduction in operating cost total savings post tax Tax saving on inc. Dep Total cashflow Discount factor 12% Dis. Cash flow 80,000 1 2,000 11,000 8450 1,881 10,331 0.893 9,226 20,000 2 3,000 11,000 9100 1,881 10,981 0.797 8,752 40,000 3 4,000 11,000 9750 1,881 11,631 0.712 8,281 4 4,000 11,000 9750 1,881 11,631 0.636 7,397 5 4,000 11,000 9750 1,881 11,631 0.567 6,595 6 4,000 11,000 9750 1,881 11,631 0.507 5,897 5,000 7 4,000 11,000 9750 1,881 11,631 0.452 5,257 8 4,000 11,000 9750 1,881 11,631 0.404 4,699 Present value of inflow 56,104 value of outflow 60,000 NPV to replace old machine (3,896) Conclusion: since the NPV is negative the machine should not be replaced.