You have been asked if the baseball lathe needs to be replaced. The one in curre
ID: 2723652 • Letter: Y
Question
You have been asked if the baseball lathe needs to be replaced. The one in current use was bought 4 years ago at a cost of $540,000. At the time of purchase it had a nine-year life and your firm has been depreciation it using straight-line depreciation to a salvage value of zero. It can be sold today for $150,000. You have hired a consultant to determine the best replacement for the machine. The consultant has charged you $40,000 for his services. The one (with 5-year Economic life) he suggests has a cost of $850,000 and will need $50,000 worth of modifications to adapt it to your firm’s purposes. The firm has decided it can use a 5-year MACRS depreciation schedule for this machine. You expect that they can sell the machine at the end of the project (end of year 5) for $100,000. This firm expects that they can save $240,000 before tax each year if they replace the old machine. The firm has a WACC of 13.00% and ahs a marginal tax rate of 35%. The machine will allow the firm to reduce working capital by $20,000.
What is the NPV of the project? What are the MIRR, IRR and the PI of the project? Should you recommend the project to your firm? Why?
Explanation / Answer
All Amounts in $ For calculating the NPV, it is necessary to determine the cash inflows and outflows Cash Outflows at Year T = 0 Sale Value of old machine 150000 Cosultant Fees -40000 Cost of Machine -850000 Reduction in Working Capital 20000 Modifcations to Machine -50000 Total Cash Outflows -770000 Cash Inflows per year Savings before tax 240000 Less : Tax Impact @ 35% 84000 Post Tax Savings 156000 Sale Value of Machine at the end of 5 years 100000 Rate of Capital 13% Given the information above, the Net Present Value of the project works out to ($153,345.20) The Internal Rate of Return or IRR is calculated using the Trial-and-Error basis method Hence, the Internal Rate of Return or IRR works out to 4.15% The Modified Internal Rate of Return or MIRR is based on the IRR and the rate of capital both, plus the cash inflows and outflows of the project -770000 156000 156000 156000 156000 156000 100000 13% 4.15% Given these values, the MIRR works out to 4.15% The Profitability Index of the project is the present values of the cash inflows divided by the total cash outflows Year Inflows Present Value 1 156000 $464,017.53 2 156000 $368,339.81 3 156000 $260,223.98 4 156000 $138,053.10 5 256000 $256,000.00 $1,486,634.41 The total cash outflow for the project is $770,000.00 Hence, the profitability index for the project is 1.930694 : 1 Since the NPV of the project is negative, and both the IRR and MIRR are way below the rate of capital, hence the project should not be accepted.