6. Southwest Airlines is considering the purchase of a new baggage-handling mach

Question

6. Southwest Airlines is considering the purchase of a new baggage-handling machine that moves bags quicker and with less damage. The cost is $160,000. The machine will be depreciated using the straight line method over its seven year life. If the machine is purchased, SWA will save $31,000 per year in damaged bags costs during the first five years. Because of higher maintenance costs during the last two years the savings will only be $28,000. the firm is in a34% tax bracket. Given that the firm’s required rate of return is 13%, compute the NPV and IRR of the investment. Should they make the investment?

Explanation / Answer

Depreciation = Investment / No. of years = 160,000 / 7 = 22,857.14

Cash Flows = Net Income + Depreciation

NPV and IRR can be calculated using the same function on a calculator or excel

CF0 = -160,000, CF1 ....CF5 = 28,231, CF6 = CF7 = 26,251 and I/Y = 13%

=> Compute NPV = -36,936.04

and Compute IRR = 5.08%

As NPV < 0 and IRR < Cost of capital, they should not make the investment.

Southwest 0 1 2 3 4 5 6 7 Investment -$160,000.00 Savings $ 31,000.00 $ 31,000.00 $ 31,000.00 $ 31,000.00 $ 31,000.00 $ 28,000.00 $ 28,000.00 Depreciation -$22,857.14 -$22,857.14 -$22,857.14 -$22,857.14 -$22,857.14 -$22,857.14 -$22,857.14 EBT $   8,142.86 $   8,142.86 $   8,142.86 $   8,142.86 $   8,142.86 $   5,142.86 $   5,142.86 Tax (34%) -$ 2,768.57 -$ 2,768.57 -$ 2,768.57 -$ 2,768.57 -$ 2,768.57 -$ 1,748.57 -$ 1,748.57 Net Income $   5,374.29 $   5,374.29 $   5,374.29 $   5,374.29 $   5,374.29 $   3,394.29 $   3,394.29 Cash Flows -$160,000.00 $ 28,231.43 $ 28,231.43 $ 28,231.43 $ 28,231.43 $ 28,231.43 $ 26,251.43 $ 26,251.43 NPV -$36,936.04 IRR 5.08%

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