Swindle Corporation is a manufacturer of a variety of swimwear, such as suits, j

Question

Swindle Corporation is a manufacturer of a variety of swimwear, such as suits, jammers and goggles. In order to improve the quality of existing products, the production manager of the company proposes to replace a machine used in the molding process. As a financial manager of the company, you are responsible for assessing the feasibility of this project. After conducting a preliminary study, it is estimated that the project will generate additional sales revenue of $410,000 in each of the next three years. It is known that the company faces a marginal tax rate of 20% and wants a 10% required rate of return. In addition, the company employs the simplified straight-line method to compute its depreciation. To finance the project, the company has to borrow $1,000,000 at 7% interest from its bank. Other findings of the study are presented as follows:

Explanation / Answer

a) INITIAL OUTLAY: Cost of the new machine 1800000 Shipping fee and installation cost 300000 Total cost of the new machine 2100000 Net proceeds from the old machine: Current market value 990000 Book value: Original cost = 2350000+180000+110000= 2640000 Less: depreciation to date = 2640000*5/8= 1650000 Book value 990000 Gain 0 Tax on gain 0 Net proceeds from the old machine -990000 Decrease in NWC (430000+250000-360000-370000) = -50000 Incremental initial investment 1060000 b) INCREMENTAL AFTER TAX CASH FLOWS: 1 2 3 Incremental revenues 410000 410000 410000 Savings in cost of defects (140000-110000) 30000 30000 30000 Increase in maintenance costs (330000-280000) 50000 50000 50000 Incremental depreciation (2100000/3-2640000/8) 370000 370000 370000 Incremental net operating income 20000 20000 20000 Tax at 20% 4000 4000 4000 NOPAT 16000 16000 16000 Add: depreciation 370000 370000 370000 Annual OCF 386000 386000 386000 Increase in NWC 50000 Net after tax cash flows 386000 386000 436000 c) PVIF at 10% (Required rate of return) 0.90909 0.82645 0.75131 PV at 10% 350909 319010 327571 Cumulative PV 997490 Less: Initial investment 1060000 NPV -62510 AS THE NPV OF THE REPLACEMENT PROJECT IS NEGATIVE, THE COMPANY SHOULD NOT BUY THE NEW MACHINE. d) If the new machine is to be bought, the NPV of replacement should be > 0. For the NPV to be 0, the discount on the purchase price-PV of the tax shield lost due to reduction in purchase price, should equal $62510 The PV of depreciation tax shield in % terms would be (1/3)*20%*(1.1^3-1)/(0.1*1.1^3)= 16.58% So 62510 = (100%-16.58%) = 83.42% So discount should be (for 0 NPV) 62510/83.42% = 74934 CHECK: INCREMENTAL AFTER TAX CASH FLOWS: 1 2 3 Incremental revenues 410000 410000 410000 Savings in cost of defects (140000-110000) 30000 30000 30000 Increase in maintenance costs (330000-280000) 50000 50000 50000 Incremental depreciation ((2100000-74934)/3-2640000/8)) 345022 345022 345022 Incremental net operating income 44978 44978 44978 Tax at 20% 8996 8996 8996 NOPAT 35982 35982 35982 Add: depreciation 345022 345022 345022 Annual OCF 381004 381004 381004 Increase in NWC 50000 Net after tax cash flows 381004 381004 431004 PVIF at 10% (Required rate of return) 0.90909 0.82645 0.75131 PV at 10% 346367 314881 323818 Cumulative PV 985066 Less: Initial investment (1060000-74934) 985066 NPV 0 THE DISCOUNT SHOULD BE ATLEAST $74934 TO ATTRACT THE COMPANY INTO BUYING THE NEW MACHINE.

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