You have been asked if the baseball lathe needs to be replaced. The one in curre

Question

You have been asked if the baseball lathe needs to be replaced. The one in current use was bought 4 years ago at a cost of $540,000. At the time of purchase it had a nine-year life and your firm has been depreciation it using straight-line depreciation to a salvage value of zero. It can be sold today for $150,000. You have hired a consultant to determine the best replacement for the machine. The consultant has charged you $40,000 for his services. The one (with 5-year Economic life) he suggests has a cost of $850,000 and will need $50,000 worth of modifications to adapt it to your firm’s purposes. The firm has decided it can use a 5-year MACRS depreciation schedule for this machine. You expect that they can sell the machine at the end of the project (end of year 5) for $100,000. This firm expects that they can save $240,000 before tax each year if they replace the old machine. The firm has a WACC of 13.00% and ahs a marginal tax rate of 35%. The machine will allow the firm to reduce working capital by $20,000.

What is the NPV of the project? What are the MIRR, IRR and the PI of the project? Should you recommend the project to your firm? Why?

Explanation / Answer

All Amounts in $ For calculating the NPV, it is necessary to determine the cash inflows and outflows Cash Outflows at Year T = 0 Sale Value of old machine 150000 Cosultant Fees -40000 Cost of Machine -850000 Reduction in Working Capital 20000 Modifcations to Machine -50000 Total Cash Outflows -770000 Cash Inflows per year Savings before tax 240000 Less : Tax Impact @ 35% 84000 Post Tax Savings 156000 Sale Value of Machine at the end of 5 years 100000 Rate of Capital 13% Given the information above, the Net Present Value of the project works out to ($153,345.20) The Internal Rate of Return or IRR is calculated using the Trial-and-Error basis method Hence, the Internal Rate of Return or IRR works out to 4.15% The Modified Internal Rate of Return or MIRR is based on the IRR and the rate of capital both, plus the cash inflows and outflows of the project -770000 156000 156000 156000 156000 156000 100000 13% 4.15% Given these values, the MIRR works out to 4.15% The Profitability Index of the project is the present values of the cash inflows divided by the total cash outflows Year Inflows Present Value 1 156000 $464,017.53 2 156000 $368,339.81 3 156000 $260,223.98 4 156000 $138,053.10 5 256000 $256,000.00 $1,486,634.41 The total cash outflow for the project is $770,000.00 Hence, the profitability index for the project is 1.930694 : 1 Since the NPV of the project is negative, and both the IRR and MIRR are way below the rate of capital, hence the project should not be accepted.

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