The Fernandez Company has the opportunity to invest in one of two mutually exclu

Question

The Fernandez Company has the opportunity to invest in one of two mutually exclusive machines that will produce a product that the company will need for the foreseeable future. Machine A costs $4 million up-front and has a pre-tax operatin cost of $1 million per year for 4 years. After 4 years, the machine must be replaced and no salvage value is expected to be realized. Machine B costs $5 million up-front and has pre-tax operating cost of $1.2 million per year for 8 years, after which it must be replaced and will have no salvage value. Both machines fall into MACRS 5-year class, which implies recovery allowances of 20%, 32%, 19%, 12%, 11%, and 6% in yeras 1-6, respectively. Assume that machine prices and operating costs are not expected to rise because inflation will be offset by other factors. The cost of capital is 10%, and the firms marginal tax rate is 40%.

a. what are the after-tax cash flows associated with each machine?

b. What are the NPV's of the two machines?

c. What are the EAC's of the two machines? Assuming Fernandez must purchase one of the machines, which one should it purchase?

Explanation / Answer

The Fernandez Company Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 MACRS Rate   20% 32% 19% 12% 11% 6% Tax rate =40% Machine A Details of After Tax cash flows and NPV Investment in machine       4,000,000 Post Tax Operating Cost =Operating cost(1-Tax rate)              600,000           600,000           600,000          600,000 Less Depreciation Tax shield= Depreciation*Tax rate=            (320,000)         (512,000)        (304,000)       (192,000) a Net Post Tax Cash outflows       4,000,000              280,000             88,000           296,000          408,000 PV factor @10%                        1                   0.909                0.826               0.751              0.683 PV of Net Cash outflows       4,000,000              254,545             72,727           222,389          278,669 b NPV of Net cash outflows= $   4,828,331 Machine B Details of After Tax cash flows and NPV Investment in machine       5,000,000 Post Tax Operating Cost =Operating cost(1-Tax rate)              720,000           720,000           720,000          720,000         720,000          720,000        720,000      720,000 Less Depreciation Tax shield= Depreciation*Tax rate=            (400,000)         (640,000)        (380,000)       (240,000)       (220,000)        (120,000)                    -                    -   a Net Post Tax Cash outflows       5,000,000              320,000             80,000           340,000          480,000         500,000          600,000        720,000      720,000 PV factor @10%                        1                   0.909                0.826               0.751              0.683              0.621               0.564             0.513           0.467 PV of Net Cash outflows       5,000,000              290,909             66,116           255,447          327,846         310,461          338,684        369,474      335,885 b NPV of Net cash outflows= $   7,294,822 c For EAC , 8 year cycle considered Machine A Details of After Tax cash flows and NPV Investment in machine       4,000,000     4,000,000 Post Tax Operating Cost =Operating cost(1-Tax rate)              600,000           600,000           600,000          600,000         600,000          600,000        600,000      600,000 Less Depreciation Tax shield= Depreciation*Tax rate=            (320,000)         (512,000)        (304,000)       (192,000)       (320,000)        (512,000)      (304,000)    (192,000) Net Post Tax Cash outflows       4,000,000              280,000             88,000           296,000          408,000     4,280,000             88,000        296,000      408,000 PV factor @10%                        1                   0.909                0.826               0.751              0.683              0.621               0.564             0.513           0.467 PV of Net Cash outflows       4,000,000              254,545             72,727           222,389          278,669     2,657,543             49,674        151,895      190,335 NPV of Net cash outflows= $   7,877,778 Machine B Details of After Tax cash flows and NPV Investment in machine       5,000,000 Post Tax Operating Cost =Operating cost(1-Tax rate)              720,000           720,000           720,000          720,000         720,000          720,000        720,000      720,000 Less Depreciation Tax shield= Depreciation*Tax rate=            (400,000)         (640,000)        (380,000)       (240,000)       (220,000)        (120,000)                    -                    -   Net Post Tax Cash outflows       5,000,000              320,000             80,000           340,000          480,000         500,000          600,000        720,000      720,000 PV factor @10%                        1                   0.909                0.826               0.751              0.683              0.621               0.564             0.513           0.467 PV of Net Cash outflows       5,000,000              290,909             66,116           255,447          327,846         310,461          338,684        369,474      335,885 NPV of Net cash outflows= $   7,294,822 S Machine A Machine B NPV of Cash outflows       7,877,778           7,294,822 EAC Annuity factor =Sum of PV factors=                5.335                   5.335 Equivalent Annual Cost =     42,027,947        38,917,878 As the Eac of Machine B is less, it is better to   purchase Machine B

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