The Olney Company purchased a machine 3 years ago at a cost of $150,000. It had
ID: 2619842 • Letter: T
Question
The Olney Company purchased a machine 3 years ago at a cost of $150,000. It had an expected life of 10 years at the time of purchase and an expected salvage value of $5,000. The existing machine costs $54,000 year to run and generates $1,000,000 a year in revenue with a gross profit margin of 20%. The old machine can be sold today for $55,000 and the expectation is that it can be sold for $7,500 in 7 years.
A new machine with a 7 year life can be purchased for $225,000. Cash operating expenses will be $65,000 per year. The new machine will boost revenue to $1,075,000 in the first three years of operation and then revenue of the new machine will increase to $1,090,000 per annum for the balance of machine’s life. The machine has a gross profit margin of 23% due to fewer defects. At the end of its useful life, the machine will have no value. The firm's tax rate is 34 percent. Straight-line depreciation is used for all assets. The firm’s WACC is 12 percent. The firm has an ACP of 63 days and pays its bills after 25 days.
Calculate project’s NPV and IRR.
The firm reduces its ACP to 55 days and starts to pay its bills after 30 days. What will be the project’s NPV ?
Explanation / Answer
Let us first find the NPV of the project where we buy new machine and sell the existing machine today.
Let us first calculate the book value of exisiting machine so that we can find out the profit/loss on sale of existing machine and take its tax effect in our calculations.
Depreciation of existing machine per annum using SLM = 150,000 - 5,000 / 10 years = $ 14,500
book value of existing machine today = 150,000 - (14,500 * 3) = $ 106,500
we sold this existing machine today at $ 55,000 i.e we have incurred loss on sale which will give us tax benefit of (106,500-55,000)* 34% = $ 17,510
Outflow at time 0 will be = cost of buying new machine - tax benefit on loss of sale of existing machine - amount received on sale of existing machine
Outflow at Time 0 = 225,000 - 55,000 - 17,510 = $ 152,490
Cash expenses per annum = 65,000
Revenue for first 3 years = $ 1,075,000 & revenue from 4-7 = $ 1,090,000 per annum
Gross proft for first 3 years = 1075000*23% = 247,250 and gross profit from 4-7 = 1090000*23% = $ 2,50,7000
Net cash inflow for first 3 years = gross profit - cash expenses = 247250-65000 = $ 182,250-34% = 120,285
Net cash flow for 4 - 7 years = gross profit - cash expenses = 250700 - 65000 = $ 185,700 - 34% = 122,562
NPV = P.V. of inflow - P.V. of outflow
NPV = $ 401,384
IRR is that rate at which P.V. of inflow = P.V. of outflow i.e. where NPV = 0
IRR (Using trial and error method) = 77.71%
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