Beryl\'s Iced Tea currently rents a bottling machine for $53,000 per year, inclu

Question

Beryl's Iced Tea currently rents a bottling machine for $53,000 per year, including all maintenance expense. It is considering purchasing a machine instead and is comparing two options: a. Purchase the machine it is currently renting for $165,000. This machine will require $25,000 per year in ongoing maintenance expenses. b. Purchase a new, more advanced machine for $255,000. This machine will require $19,000 per year in ongoing maintenance expenses and will lower bottling costs by $10,000 per year- Also, $35,000 will be spent up front to train the new operators of the machine Suppose the appropriate discount rate is 9% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each year, as is the cost of the rental machine. Assume also that the machines will be depreciated via the straight-line method over seven years and that they have a 10-year life with a negligible salvage value. The marginal corporate tax rate is 38%. Should Beryl's Iced Tea continue to rent, purchase its current machine, or purchase the advanced machine? To make this decision, calculate the NPV of the FCF associated with each alternative. The NPV of renting the current machine is $

Explanation / Answer

Answer: To evaluate the free cash flows associated with each alternative. Note that we only need to include the components of free cash flows that vary across each alternative. For example, since NWC is the same for each alternative, we can ignore it.

The spreadsheet below computes the relevant FCF from each alternative. Note that each alternative has a negative NPV .This represents the PV of the costs of each alternative. We should choose the one with the highest NPV (lowest cost), which in this case is renting the machine.

Rent Machine Particulars/years 0 1 2 3 4 5 6 7 8 9 10 Rent -53000 -53000 -53000 -53000 -53000 -53000 -53000 -53000 -53000 -53000 FCF (rent) -32860 -32860 -32860 -32860 -32860 -32860 -32860 -32860 -32860 -32860 NPV at 9%           -210884.20902 (32860*6.417657) Note: PVAF 9% is 6.417657 for 10 years andFCF = 53000*(1-0.38)=32860

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