A firm is considering an investment in a new machine with a price of $18.15 mill

Question

A firm is considering an investment in a new machine with a price of $18.15 million to replace its existing machine. The current machine has a book value of $6.15 million and a market value of $4.65 million. The new machine is expected to have a four-year life, and the old machine has four years left in which it can be used. If the firm replaces the old machine with the new machine, it expects to save $6.85 million in operating costs each year over the next four years. Both machines will have no salvage value in four years. If the firm purchases the new machine, it will also need an investment of $265,000 in net working capital. The required return on the investment is 12 percent, and the tax rate is 35 percent. Assume the company uses straight-line depreciation. What is the NPV of the decision to keep the old machine? What is the IRR of the decision to keep the old machine?

Explanation / Answer

initial investment

= 4650000 * (1-0.35) = 3022500

depriciation = 6150000/4 = 1,537500

operation cash flow = 1537500 * 0.35 = 538125

NPV = -3022500 + 538125 * [1- (1.12)^-4]/0.12

= -1,388,026.38

IRR = 27.82%

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