Bull Gator Industries is considering a new assembly line costing $6,000,000. The assembly line will be fully depreciated by the simplified straight line method over its 5 year depreciable life. Operating costs of the new machine are expected to be $1,100,000 per year. The existing assembly line has 5 years remaining before it will be fully depreciated and has a book value of $3,000,000. If sold today the company would receive $2,400,000 for the existing machine. Annual operating costs on the existing machine are $2,100,000 per year. Bull Gator is in the 46 percent marginal tax bracket and has a required rate of return of 12 percent.
a. Calculate the net present value of replacing the existing machine.
b. Explain the impact on NPV of the following:
i. Required rate of return increases
ii. Operating costs of new machine are increased
iii. Existing machine sold for less
Answer:
a. Calculate Initial Outlay
Purchase Price $6,000,000
Sale of old (2,400,000)
Tax savings from sale
($3,000,000 - 2,400,000).46 (276,000)
Initial Outlay $3,324,000
Free Cash Flows
Change in EBDIT $1,000,000
-Increased Depreciation - 600,000
Change in EBIT $400,000
-Taxes (at 46%) - 184,000
+Change in Depreciation + 600,000
-Change in Working Capital - 0
-Change in Capital Spending - 0
$816,000
Depreciation on old machine
$3,000,000/5 = $600,000
Depreciation on new machine
$6,000,000/5 = $1,200,000
Increase Depreciation
= $600,000 - $1,200,000 = -$600,000
Calculate NPV
NPV = $816,000 × 3.605 - $3,324,000
NPV = -$382,320
b. i. NPV decreases because the present value of the future cash flows decreases
ii. NPV decreases because cash flows decrease
iii. NPV decreases because this reduces the cash flow from salvage sale
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