ADR Corporation is considering the replacement of its Grounding Grinding (GG) ma
ID: 1175448 • Letter: A
Question
ADR Corporation is considering the replacement of its Grounding Grinding (GG) machine The old machine was purchased 4 years ago at an installed cost of $238.000 It is being depreciated straight ine over 7 years t could be sold now tor $69 500 The new GG machine will cost $253,000 with installation costs of $5,000 It wall be depreciated straight I.ne over 6 years The firm's tax rate is 40% Estimated annual Net Cash Benefits for the two GG machines are Old Machine New Machine ? $80 000 Years), 2 3-6 7-8 $80,000 $87,000 $77 000 $51.000 $43.000 $40.000 $35.000 1 Calculate the initial investment for this replacement project 2 Calculate the incremental annual cash flows for the project 3 The company's cost of capital is 8% Assuming the GG machine is of average risk calculate the replacement project's Net Present Value Is the project acceptable? Why? ject 4 Calculate the replacement project's Internal Rate of Return Is the pro acceptable? Why? 5. Assume that this project's risk is assumed to be greater than average for the company Calculate the replacement project's Net Present Value based on a risk adjusted interest rate of 11% . Using Internal Rate of Return, is the replacement project acceptable based on the assumption of higher risk? Why?Explanation / Answer
1 CALCULATION OF INITIAL INVESTMENT OF REPLACEMENT PROJECT A Cost of new machine $253,000 B Installation cost $5,000 C Salvage value of old machine $69,500 D=A+B-C Initial investment for the replacement project $188,500 2 CALCULATION OF INCREMENTAL ANNUAL CASH FLOW Depreciation Tax Shield Annual depreciation of old machine $ 34,000 (238000/7) Annual depreciation tax shield(old machine) $ 13,600 (34000*0.4) AnnualDepreciation of new machine $ 43,000 (253000+5000)/6 Annual depreciation tax shield(New machine) $ 17,200 (43000*0.4) E F G=F-E Tax Shield Tax Shield Incremental Year Old machine New Machine Tax Shield 1 $ 13,600 $ 17,200 $ 3,600 2 $ 13,600 $ 17,200 $ 3,600 3 $ 13,600 $ 17,200 $ 3,600 4 $0 $ 17,200 $ 17,200 5 $0 $ 17,200 $ 17,200 6 $0 $ 17,200 $ 17,200 Annual net cash benefits H I J=I-H Cash benefit Cash Benefit Incremental Year Old Machine New machine Cash Benefit 1 $51,000 $80,000 $29,000 2 $43,000 $80,000 $37,000 3 $40,000 $87,000 $47,000 4 $40,000 $87,000 $47,000 5 $40,000 $87,000 $47,000 6 $40,000 $87,000 $47,000 7 $35,000 $77,000 $42,000 8 $35,000 $77,000 $42,000 Incremental AnnualCash Flow L M P=L+M Incremental Incremental Incremental Year Tax Shield After tax benefit Cash flow 1 $ 3,600 $29,000 $ 32,600 2 $ 3,600 $37,000 $ 40,600 3 $ 3,600 $47,000 $ 50,600 4 $ 17,200 $47,000 $ 64,200 5 $ 17,200 $47,000 $ 64,200 6 $ 17,200 $47,000 $ 64,200 7 $0.00 $42,000 $ 42,000 8 $0.00 $42,000 $ 42,000 3 CALCULATION OF NET PRESENT VALUE Present Value (PV) of Cash Flow: (Cash Flow)/((1+i)^N) i=Discount Rate=8%=0.08 N=Year of Cash Flow N R PV=R/(1.08^N) Year Cash flow PV of Cash Flow 0 ($188,500) -188500 1 $ 32,600 30185.18519 2 $ 40,600 34807.9561 3 $ 50,600 40167.9114 4 $ 64,200 47188.91655 5 $ 64,200 43693.44125 6 $ 64,200 40456.89005 7 $ 42,000 24506.5966 8 $ 42,000 22691.29315 SUM 95198.19028 Net Present Value=Sumof PV of cash flows Net Present Value(NPV) $ 95,198 The Project is acceptable The NPV of the project is positive 4 CALCULATION OF INTERNAL RATE OF RETURN N R Year Cash flow 0 ($188,500) 1 $32,600 2 $40,600 3 $50,600 4 $64,200 5 $64,200 6 $64,200 7 $42,000 8 $42,000 Using IRR function of excel over the cash flow: InternalRateof return(IRR) 19.32% Project is acceptable IRR is greater than the hurdle rate of 8% 5 CALCULATION OFvNPV BASED ON 11% DISCOUNT N R PV=R/(1.11^N) Year Cash flow PV of Cash Flow 0 ($188,500) -188500 1 $32,600 29369.36937 2 $40,600 32951.87079 3 $50,600 36998.28389 4 $64,200 42290.52854 5 $64,200 38099.57526 6 $64,200 34323.94168 7 $42,000 20229.65326 8 $42,000 18224.91284 SUM 63988.13563 Net Present Value=Sumof PV of cash flows Net Present Value(NPV) $ 63,988 The Project is acceptable The NPV of the project is positive 6 Using Internal rate of return,project is acceptable The IRR is higher than hurdle rate of 11%
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