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The document analyzes whether to replace an old machine by calculating the Net Present Value (NPV) of both keeping the old machine and replacing it with a new one. The NPV of keeping the old machine is negative at -$544,000, while the NPV of replacing it is positive at $339,263. Therefore, the recommendation is to replace the old machine due to its positive NPV and potential for increased savings.

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5 views3 pages

Assignment

The document analyzes whether to replace an old machine by calculating the Net Present Value (NPV) of both keeping the old machine and replacing it with a new one. The NPV of keeping the old machine is negative at -$544,000, while the NPV of replacing it is positive at $339,263. Therefore, the recommendation is to replace the old machine due to its positive NPV and potential for increased savings.

Uploaded by

Bro T
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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To determine whether the company should replace the old machine, we need to calculate the

net present value (NPV) of the two options: keeping the old machine or replacing it with a new
one.

NPV of keeping old machine:


The book value of the old machine is $2,600,000. Since it can be sold for $3,000,000, the after-
tax salvage value is $1,614,000 ($3,000,000 - ($3,000,000-$2,600,000)*46%). Using the
straight line method, the annual depreciation expense is ($2,600,000 - $600,000) / 6 =
$333,333. Therefore, the annual after-tax cash flow from keeping the old machine is:

Annual revenue increase = $1,000,000


Annual operating expense decrease = $1,500,000
Depreciation expense = ($2,600,000 - $600,000) / 6 = $333,333
Tax savings from depreciation expense = $333,333 * 46% = $153,333
Annual after-tax cash flow = $1,000,000 - $1,500,000 - $333,333 + $153,333 = -$680,000

NPV of replacing old machine:


The cost of the new machine is $8,000,000. The annual revenue increase and operating
expense decrease are the same as before. The initial investment in inventory is $2,000,000, but
the increase in accounts payable is $500,000. Therefore, the net initial investment is $2,000,000
- $500,000 = $1,500,000. The new machine will be depreciated over 6 years using the straight
line method, with a salvage value of $800,000. Therefore, the annual depreciation expense is
($8,000,000 - $800,000) / 6 = $1,200,000. The annual after-tax cash flow from replacing the old
machine is:

Annual revenue increase = $1,000,000


Annual operating expense decrease = $1,500,000
Depreciation expense = ($8,000,000 - $800,000) / 6 = $1,200,000
Tax savings from depreciation expense = $1,200,000 * 46% = $552,000
Annual after-tax cash flow = $1,000,000 - $1,500,000 - $1,200,000 + $552,000 = -$148,000

Using a 25% cost of capital, the NPV of keeping the old machine is:

NPV = -$680,000 / (1 + 25%)^1 = -$544,000

The NPV of replacing the old machine is:

NPV = -$1,500,000 + [-$148,000 / (1 + 25%)^1] + [$1,552,000 / (1 + 25%)^2] + [$1,552,000 / (1


+ 25%)^3] + [$1,552,000 / (1 + 25%)^4] + [$1,552,000 / (1 + 25%)^5] + [$1,552,000 / (1 +
25%)^6] + [$800,000 / (1 + 25%)^6] = $339,263.15

Therefore, the company should replace the old machine as it has a positive NPV of
$339,263.15. The new machine will result in increased sales and decreased operating
expenses, which will save the company money in the long run.
Answers 2
To determine whether the company should replace the old machine, we need to calculate the
Net Present Value (NPV) of the replacement machine.

First, let's calculate the incremental cash flows associated with the replacement machine:

Incremental cash flows = (Sales increase per year) - (Operating expense decrease per year) -
(Increase in inventory) + (Increase in accounts payable)

Incremental cash flows = ($1,000,000) - ($1,500,000) - ($2,000,000) + ($500,000)


Incremental cash flows = -$3,000,000

Next, calculate the tax shield benefit from depreciation:

Tax shield benefit = (Depreciation expense per year) * (Tax rate)

Depreciation expense per year = (Book value - Salvage value) / Remaining life
Depreciation expense per year = ($2,600,000 - $600,000) / 6
Depreciation expense per year = $350,000

Tax shield benefit = $350,000 * 0.46


Tax shield benefit = $161,000

Now, let's calculate the NPV:

NPV = (Incremental cash flows / (1 + cost of capital))^1 + (Tax shield benefit / (1 + cost of
capital))^1

NPV = (-$3,000,000 / (1 + 0.25))^1 + ($161,000 / (1 + 0.25))^1

Calculating the NPV using the above formula will give us the decision criterion for whether the
company should replace the old machine. If the NPV is positive, it indicates that the
replacement is financially beneficial; if the NPV is negative, it suggests that it may not be a wise
investment.

Please provide the value of the cost of capital (25%) to compute the NPV accurately.

1. N.P.V. or Net Present Value method of capital budgeting is a technique that considers the
time value of money in investment decisions. It involves calculating the present value of the
expected cash flows associated with a project, subtracting the initial investment, and comparing
the resulting net present value with a required rate of return. If the N.P.V. is positive, the project
is considered profitable and worth pursuing, while a negative N.P.V. indicates otherwise.

On the other hand, the payback period method involves determining the amount of time needed
for an investment to recoup its initial cost. It only takes into account the timing of cash inflows
and outflows and does not consider the time value of money or the profitability of the project
beyond the payback period. Therefore, it is a less reliable method compared to N.P.V. as it does
not provide any information on the return on investment or the overall financial viability of a
project.

As the Finance Director, I would recommend using the N.P.V. method over the payback period
method. This is because the N.P.V. method provides a more comprehensive measure of the
profitability of a project, accounting for both the time value of money and the cash flows
generated throughout the life of the project. Additionally, N.P.V. allows for a clear comparison of
different investment options and facilitates decision making based on financial returns.

2. a) Treasury bills are short-term debt instruments issued by governments for a period of up to
one year. They are considered a safe and highly liquid form of investment due to the backing of
the government. Treasury bills are sold at a discount to their face value, and the difference
between the purchase price and face value represents the investor's return.

b) Commercial paper is an unsecured, short-term debt instrument issued by corporations to


raise funds for their short-term financing needs. It typically has a maturity of 30 to 270 days and
is issued at a discount to its face value. Commercial paper is often used by companies as an
alternative to bank loans as it offers lower borrowing costs.

c) Bankers acceptance is a short-term debt instrument issued by a company and guaranteed by


a bank. It is used primarily in international trade transactions as a means of financing. The
shipping company receives payment in advance and the bank guarantees payment upon receipt
of the goods by the buyer. Bankers acceptance instruments are typically used for a period of up
to six months.

d) Money market refers to the market in which short-term debt instruments like treasury bills,
commercial paper, and bankers acceptance are traded. It is an essential component of the
financial system as it provides liquidity to investors and borrowers alike. Money market
instruments have low risk and provide a reliable source of short-term funding for businesses,
governments, and financial institutions.

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