Management is considering the purchase of a new machine with a purchase price of

Question

Management is considering the purchase of a new machine with a purchase price of $900,000. If purchased, employees will complete a series of training sessions that are expected to cost $20,000. The machine is expected to last 5 years. It will be depreciated for tax purposes at the rate of $168,000 per year. Management has estimated that the machine can be sold for $60,000 at the end of its 5-year life. Purchase and use of the machine is expected to increase sales substantially and quickly. In fact, annual EBITDA is expected to be larger in each of the five years, compared to our results if we do not purchase the machine, requiring a one-time increase in working capital of $40,000 at the beginning of the investment period. If the firm is subject to a tax rate of 30% and a required rate of return of 15%, by how much must the equal annual EBITDA increase in each of the five years in order for the purchase of the new machine to be justified? Show your work.

Explanation / Answer

Solution.

We have,

Cumulative PVF @15% for 5 years = 3.352

PVF @15% for 5th Year = 0.497

Let annual increase in EBITDA be "x"

Calculation of Net Cash Flows if machine is purchased:

For the purchase to be justified Net Cash inflow by purchase of machine should be more then outflow in other option i.e., $40000

$3.352x-$721239 = $40000

x = $761239 / 3.352

x = $227100

Thus the annual EBITDA should increase by $227100

Current Outflow (for purchase of machine) ($900000) Training cost of employees ($20000) PV of tax saving on depreciation (168000*30%*3.352) $168941 PV of salvage value of machine (60000*0.497) $29820 PV on increase in EBITDA $3.352x Net Cash Flow $3.352x - $721239

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