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Beryl's Iced Tea currently rents a bottling machine for $50,000 per? year, including all maintenance expenses
Beryl's Iced Tea currently rents a bottling machine for $50,000 per? year, including all maintenance expenses. It is considering purchasing a machine instead and is comparing two? options:
a. Purchase the machine it is currently renting for $150,000. This machine will require $21,000 per year in ongoing maintenance expenses.
b. Purchase a? new, more advanced machine for $265,000. This machine will require $17,000 per year in ongoing maintenance expenses and will lower bottling costs by $11,000 per year.? Also, $40,000 will be spent up front to train the new operators of the machine.
Suppose the appropriate discount rate is 7% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each? year, as is the cost of the rental machine. Assume also that the machines will be depreciated via the?straight-line method over seven years and that they have a? 10-year life with a negligible salvage value. The marginal corporate tax rate is 35%. Should? Beryl's Iced Tea continue to? rent, purchase its current? machine, or purchase the advanced? machine? To make this? decision, calculate the NPV of the FCF associated with each alternative.
Expert Solution
| PV of Cash Outflows under Renting option: | |||
| Year End | Rentals After Tax | PVAF @ 7% | Total PV |
| 1-7 | -32,500.00 | 5.3893 | -1,75,151.91 |
| Working Note 1: Computation of Rentals After Tax | |||
| Particulars | Amount in $ | ||
| Rental | -50,000.00 | ||
| Tax Saving | 17,500.00 | ||
| Rentals after Tax | -32,500.00 |
| PV of Cash Outflows under Purchasing Current Machine option: | |||
| Year | Cash Flows | PVF @ 7% | Total PV |
| 0 | -1,50,000.00 | 1 | -1,50,000.00 |
| 1-7 | -6,150.00 | 5.3893 | -33,144.13 |
| -1,83,144.13 | |||
| Working Note 2: Computation of Cash flow per year | |||
| Particulars | Amount in $ | ||
| Cash Flow - Maintenance Expenses | -21,000.00 | ||
| Depreciation per year | 21,428.57 | ||
| Loss Before Taxes | -42,428.57 | ||
| Tax saving on losses | -14,850.00 | ||
| Loss After Tax saving | -27,578.57 | ||
| Depreciation per year | 21,428.57 | ||
| Cash Outflow After Tax | -6,150.00 |
| PV of Cash Outflows under Purchasing Advanced Machine option: | ||||
| Year | Cash Flows | PVF @ 7% | Total PV | |
| 0 | -3,05,000.00 | 1 | -3,05,000.00 | |
| 1-7 | 9,350.00 | 5.3893 | 50,389.86 | |
| -2,54,610.14 | ||||
| Working Note 3: Computation of Cash flow per year | ||||
| Particulars | Amount in $ | |||
| Cash Flow - Maintenance expenses | -17,000.00 | |||
| Savings on Bottling cost | 11,000.00 | |||
| Net Cash Outflow | -6,000.00 | |||
| Depreciation per year | 37,857.14 | |||
| Loss Before Taxes | -43,857.14 | |||
| Tax saving on losses | -15,350.00 | |||
| Loss After Tax saving | -28,507.14 | |||
| Depreciation per year | 37,857.14 | |||
| Cash Inflow After Tax | 9,350.00 |
Decision: It is better to continue renting Machine as present Value of cash Outflow is least in this case.
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