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 $155,000. This machine will require $23,000 per year in ongoing maintenance expenses.

b. Purchase a new, more advanced machine for $265,000. This machine will require $17,000 per year in ongoing maintenance expenses and will lower bottling costs by $11,000 per year. Also, $37,000 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.

Explanation / Answer

Calculation of per year after tax cash flow in case of renting of machine After tax cash outflow per year = Rent - Tax saving = $54000 - ($54000 * 35%) = $35100 Calculation of per year after tax cash flow in case of Purchase of curent machine Option A Cost of machine = $155000 Depreciation per year = $155000 / 7 years = $22143 After tax cash outflow per year = $23000 - ($45143 * 35%) = $7200 Calculation of per year after tax cash flow in case of Purchase of Advanced machine Option B Cost of machine = $265000 Depreciation per year = $265000 / 7 years = $37857 After tax cash outflow per year = ($17000 - $11000) - ($43857 * 35%) = -$9350 Calculation of NPV of FCF Renting a machine Purchase a Current Machine Purchase a advanced machine Year PV Factor @ 7% Cash flow PV Cash flow PV Cash flow PV 0 1 $0 $0 $1,55,000 $1,55,000 $3,02,000 $3,02,000 1 0.934579439 $35,100 $32,804 $7,200 $6,729 -$9,350 -$8,738 2 0.873438728 $35,100 $30,658 $7,200 $6,289 -$9,350 -$8,167 3 0.816297877 $35,100 $28,652 $7,200 $5,877 -$9,350 -$7,632 4 0.762895212 $35,100 $26,778 $7,200 $5,493 -$9,350 -$7,133 5 0.712986179 $35,100 $25,026 $7,200 $5,134 -$9,350 -$6,666 6 0.666342224 $35,100 $23,389 $7,200 $4,798 -$9,350 -$6,230 7 0.622749742 $35,100 $21,859 $7,200 $4,484 -$9,350 -$5,823 8 0.582009105 $35,100 $20,429 $7,200 $4,190 -$9,350 -$5,442 9 0.543933743 $35,100 $19,092 $7,200 $3,916 -$9,350 -$5,086 10 0.508349292 $35,100 $17,843 $7,200 $3,660 -$9,350 -$4,753 NPV $2,46,528 $2,05,570 $2,36,330 Beryl's Iced Tea should purchase a current machine as its NPV of futue cash outflow is less compared to other two options.

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