TM company is considering replacing its machine with a new model that sells for

Question

TM company is considering replacing its machine with a new model that sells for $40,000, the cost of installation is $6,000. The old machine has been fully depreciated and has a $2500 salvage value. The new machine will be depreciated as a 3-year MACRS asset. Revenues are expected to increase $18,000 per year over the 5-year life of the new machine. At the end of 5 years the new machine is expected to have a $1500 salvage value. What are the NPV IRR for this project if TM has a required rate of return of 14% and a marginal tax rate of 35%? Operating costs are not expected to increase from the current level of $8,000 per year. Discuss your recommendations.

Explanation / Answer

0 1 2 3 4 5 Incremental revenue 18000 18000 18000 18000 18000 Depreciation MACRS (3 year) 15332 20447 6813 3409 0 Incremental NOI 2668 -2447 11187 14591 18000 Tax at 35% 934 -856 3916 5107 6300 Incremental NOPAT 1734 -1591 7272 9484 11700 Add: Depreciation 15332 20447 6813 3409 0 Incremental OCF 17066 18856 14084 12893 11700 Capital expenditure: New machine (including installation) 46000 Salvage value of old machine net of tax (2500*65%) -1625 Salvage value of new machine net of tax (1500*65%) -975 Project cash flows -44375 17066 18856 14084 12893 12675 PVIF at 14% 1.00000 0.87719 0.76947 0.67497 0.59208 0.51937 PV at 14% -44375 14970 14509 9507 7634 6583 NPV 8828 Note: Operating costs do not increase; hence incremental operating costs = 0 CALCULATION OF IRR: NPV IRR is that discount rate for which NPV is 0. The value of IRR is to be found out by trial and error by trying different discount rates till NPV becomes 0. Project cash flows -44375 17066 18856 14084 12893 12675 Discounting at 22% PVIF at 22% 1 0.81967 0.67186 0.55071 0.45140 0.37000 PV at 22% -44375 13989 12669 7756 5820 4690 549 As NPV is marginally positive, discount with 23%. PVIF at 23% 1 0.81301 0.66098 0.53738 0.43690 0.35520 PV at 23% -44375 13875 12464 7569 5633 4502 -332 NPV with 23% is marginally negative. Hence, IRR lies between 22% and 23%. The value of IRR can be found out by simple interpolation as below: IRR = 22+549/(549+332) = 22.62% (Answer) RECOMMENDATION: AS THE NPV IS POSITIVE, THE REPLACEMENT CAN BE MADE.

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