Beryl\'s Iced Tea currently rents a bottling machine for $54,000 per year, inclu

Question

Beryl's Iced Tea currently rents a bottling machine for $54,000 per year, including all maintenance expenses. It is considering purchasing a machine instead and is comparing two options a. Purchase the machine it is currently renting for $150,000. This machine will require $20,000 per year in ongoing maintenance expenses. b. Purchase a new, more advanced machine for $255,000 This machine will require $17,000 per year in ongoing maintenance expenses and will lower bottling costs by $11,000 per year. Also, $39,000 will be spent up front to train the new operators of the machine. Suppose the appropriate discount rate is 7 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 35 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 (Round to the nearest dollar

Explanation / Answer

Option A items Year 0 1 2 3 4 5 6 7 8 9 10 Initial Cost of Machine 150000 Maintenace Cost 20000 20000 20000 20000 20000 20000 20000 20000 20000 20000 Rental Income 54000 54000 54000 54000 54000 54000 54000 54000 54000 54000 Depreciation 21428.57 21428.57 21428.57 21428.57 21428.57 21428.57 21428.57 0 0 0 Income before Tax 12571.43 12571.43 12571.43 12571.43 12571.43 12571.43 12571.43 34000 34000 34000 Tax Rate 35% 35% 35% 35% 35% 35% 35% 35% 35% 35% Income after tax 8171.429 8171.429 8171.429 8171.429 8171.429 8171.429 8171.429 22100 22100 22100 free operating cash flow 29600 29600 29600 29600 29600 29600 29600 22100 22100 22100 free operating cash flow = Income after tax + depreciation Depreciation = Initial cost / 7 ( as it is as per SLM and only for 7 years) Net Present value = Present value of cash inflows - initial investment Discount Rate = 7% Net Present value = 29600*(1-1/1.07^7)/.07 + 29600/1.07^8 + 29600/1.07^9 + 29600/1.07^10 - 150000 Net Present value = 57898.01 Option B items Year 0 1 2 3 4 5 6 7 8 9 10 Initial Cost of Machine 255000 Maintenace Cost 17000 17000 17000 17000 17000 17000 17000 17000 17000 17000 Benefit in bottling cost 11000 11000 11000 11000 11000 11000 11000 11000 11000 11000 Training cost 39000 Rental Income 54000 54000 54000 54000 54000 54000 54000 54000 54000 54000 Depreciation 36428.57 36428.57 36428.57 36428.57 36428.57 36428.57 36428.57 0 0 0 Income before Tax 11571.43 11571.43 11571.43 11571.43 11571.43 11571.43 11571.43 48000 48000 48000 Tax Rate 35% 35% 35% 35% 35% 35% 35% 35% 35% 35% Income after tax 7521.429 7521.429 7521.429 7521.429 7521.429 7521.429 7521.429 31200 31200 31200 free operating cash flow 43950 43950 43950 43950 43950 43950 43950 31200 31200 31200 free operating cash flow = Income after tax + depreciation Depreciation = Initial cost / 7 ( as it is as per SLM and only for 7 years) Net Present value = Present value of cash inflows - initial investment Discount Rate = 7% Net Present value = 43950*(1-1/1.07^7)/.07 + 31200/1.07^8 + 31200/1.07^9 + 31200/1.07^10 - 255000 - 39000 Net Present value = -6150.82 Since NPV of option A is positive and NPV of option B is negative so Option A should be accepted.

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