APM Co. currently owns a machine that has 5 years of useful remaining years. Its

Question

APM Co. currently owns a machine that has 5 years of useful remaining years. Its current net book value is RM50,000. It is being depreciated using simplified straight line method to zero salvage value in 5 years. The existing machine generates RM60,000 per year in sales revenue, requiring RM20,000 in operating expenses. If the firm sells the machine now, it could get RM30,000 for it.

The firm is considering buying a new machine to replace the existing machine. The new machine costs RM100,000, needs RM5,000 to be installed properly and will result in an increase in earnings before interest and taxes of RM85,000 a year. This machine has an expected life of 5 years, after which it will have no salvage value. The firm uses simplified straight line method for depreciation. To operate this machine properly, workers would have to go through a training session that would requireRM10,000. The machine would also require an increase in inventory of RM15,000 and increase in account payable of RM5,000. Assume the tax rate is 28% and a required rate of return of 15%.

Questions:
a) Calculate the initial outlays.
b) Calculate the annual cash flows for year 1 until 5.
c) Calculate the terminal cash flow.
d) Calculate the NPV from replacing the old machine. Should investment in the new machine be accepted or rejected? Why?

Explanation / Answer

a) Calculate the initial outlays.

Old machine = price now = 30,000
New machine = sum of all the initial costs = 100,000 + 5,000 +10,000 + 15,000 + 5,000 = 135,000

b) Calculate the annual cash flows for year 1 until 5.

OLD MACHINE:
BTCF = Revenue - Expenses = 60,000 - 20,000 = 40,000
Depreciation = Initial cost/N = 30,000/5 = 6,000
Taxable Income = BTCF - Depreciation = 40,000 - 6,000 = 34,000
Tax = Taxable Income * Tax rate = 34,000 * 28% = 9,520
ATCF = BTCF - Tax = 40,000 - 9,520 = 30,480

NEW MACHINE:
BTCF = Increase in earnings before interest and taxes = 85,000
Depreciation = Initial cost/N = 135,000/5 = 27,000
Taxable Income = BTCF - Depreciation = 85,000 - 27,000 = 58,000
Tax = Taxable Income * Tax rate = 58,000 * 28% = 16,240
ATCF = BTCF - Tax = 85,000 - 16,240 = 68,760

d) Calculate the NPV from replacing the old machine. Should investment in the new machine be accepted or rejected? Why?

Old machine = - 30,000 + 30,480(P/A,i=15%,N=5) = - 30,000 + 30,480(4.3992) = 104,086.20
New machine = - 135,000 + 68,760(P/A,i=15%,N=5) = - 135,000 + 68,760(4.3992) = 149,933.18

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