Your firm is thinking about replacing equipment in its production facilities. When considering the replacement, you

Question

Your firm is thinking about replacing equipment in its production facilities. When considering the replacement, you obtain the following information: The expansion will require the company to purchase today (t = 0) $5,000,000 of new equipment. An additional $200,000 in installation charges will be required. The equipment will be depreciated as MACRS 3-year over the following four years at the following rates: t = 1 33% t = 2 45% t = 3 15% t = 4 7% The expansion will require the company to increase its net operating working capital by $150,000 today (t = 0). This net operating working capital will be recovered at the end of the projects 5 year economic life. The old equipment is fully depreciated (book value = $0) and it can be sold for $85,000. The new equipment is expected to have a salvage value of $30,000 at the end of its 5 year economic life. Your firms operating costs, excluding depreciation, are expected to reflect a decrease of $75,000 per year for each year the new equipment

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WORKSHEET: 0 1 2 3 4 5 Increase in sales $ 3,000,000 $ 3,500,000 $ 2,500,000 $ 1,500,000 $ 1,000,000 +Decrease in operating costs $ 75,000 $ 75,000 $ 75,000 $ 75,000 $ 75,000 -Depreciation $ 1,716,000 $ 2,340,000 $ 780,000 $ 364,000 $ - $ 5,200,000 =NOI $ 1,359,000 $ 1,235,000 $ 1,795,000 $ 1,211,000 $ 1,075,000 -Tax at 40% $ 543,600 $ 494,000 $ 718,000 $ 484,400 $ 430,000 =NOPAT $ 815,400 $ 741,000 $ 1,077,000 $ 726,600 $ 645,000 +Depreciation $ 1,716,000 $ 2,340,000 $ 780,000 $ 364,000 $ - =OCF $ 2,531,400 $ 3,081,000 $ 1,857,000 $ 1,090,600 $ 645,000 -Capital expenditure [5000000+200000] $ 5,200,000 +After tax salvage value of old equipment = 85000*(1-40%) = $ 51,000 +After tax salvage value of new equipment = 30000*(1-40%) = $ 18,000 -Change in NWC $ 150,000 $ - $ - $ - $ - $ (150,000) =FCF $ (5,299,000) $ 2,531,400 $ 3,081,000 $ 1,857,000 $ 1,090,600 $ 813,000 PVIF at 10% 1 0.90909 0.82645 0.75131 0.68301 0.62092 PV at 10% $ (5,299,000) $ 2,301,273 $ 2,546,281 $ 1,395,192 $ 744,894 $ 504,809 NPV [Sum of PV of FCF of years 0 to 5] $ 2,193,449 CALCULATION OF IRR: IRR is that discount rate for which NPV is 0. It has to be arrived at by trial and error, by trying out different discount rates till 0 NPV is reached. Discounting at 30%: FCF $ (5,299,000) $ 2,531,400 $ 3,081,000 $ 1,857,000 $ 1,090,600 $ 813,000 PVIF at 30% 1 0.76923 0.59172 0.45517 0.35013 0.26933 PV at 30% $ (5,299,000) $ 1,947,231 $ 1,823,077 $ 845,244 $ 381,849 $ 218,965 NPV $ (82,635) Discounting at 29%:

Year 1	$3,000,000
Year 2	$3,500,000
Year 3	$2,500,000
Year 4	$1,500,000
Year 5	$1,000,000

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Your firm is thinking about replacing equipment in its production facilities

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WORKSHEET:
	0	1	2	3	4	5
Increase in sales		$ 3,000,000	$ 3,500,000	$ 2,500,000	$ 1,500,000	$ 1,000,000
+Decrease in operating costs		$ 75,000	$ 75,000	$ 75,000	$ 75,000	$ 75,000
-Depreciation		$ 1,716,000	$ 2,340,000	$ 780,000	$ 364,000	$ -	$ 5,200,000
=NOI		$ 1,359,000	$ 1,235,000	$ 1,795,000	$ 1,211,000	$ 1,075,000
-Tax at 40%		$ 543,600	$ 494,000	$ 718,000	$ 484,400	$ 430,000
=NOPAT		$ 815,400	$ 741,000	$ 1,077,000	$ 726,600	$ 645,000
+Depreciation		$ 1,716,000	$ 2,340,000	$ 780,000	$ 364,000	$ -
=OCF		$ 2,531,400	$ 3,081,000	$ 1,857,000	$ 1,090,600	$ 645,000
-Capital expenditure [5000000+200000]	$ 5,200,000
+After tax salvage value of old equipment = 85000*(1-40%) =	$ 51,000
+After tax salvage value of new equipment = 30000*(1-40%) =						$ 18,000
-Change in NWC	$ 150,000	$ -	$ -	$ -	$ -	$ (150,000)
=FCF	$ (5,299,000)	$ 2,531,400	$ 3,081,000	$ 1,857,000	$ 1,090,600	$ 813,000
PVIF at 10%	1	0.90909	0.82645	0.75131	0.68301	0.62092
PV at 10%	$ (5,299,000)	$ 2,301,273	$ 2,546,281	$ 1,395,192	$ 744,894	$ 504,809
NPV [Sum of PV of FCF of years 0 to 5]	$ 2,193,449
CALCULATION OF IRR:
IRR is that discount rate for which NPV is 0. It has to be arrived at by trial and error, by trying out different discount rates till 0
NPV is reached.
Discounting at 30%:
FCF	$ (5,299,000)	$ 2,531,400	$ 3,081,000	$ 1,857,000	$ 1,090,600	$ 813,000
PVIF at 30%	1	0.76923	0.59172	0.45517	0.35013	0.26933
PV at 30%	$ (5,299,000)	$ 1,947,231	$ 1,823,077	$ 845,244	$ 381,849	$ 218,965
NPV	$ (82,635)
Discounting at 29%:
FCF	$ (5,299,000)	$ 2,531,400	$ 3,081,000	$ 1,857,000	$ 1,090,600	$ 813,000
PVIF at 29%	1	0.77519	0.60562	0.47314	0.36964	0.28878
Pv at 29%	$ (5,299,000)	$ 1,962,326	$ 1,865,916	$ 878,622	$ 403,131	$ 234,780
NPV	$ 45,774
IRR = 29%+1%*45774/(45774+82635) =	29.36%
ANSWERS:
a. Forecast the NINV, NCFs and Terminal Value:
Net Initial investment =	$ (5,299,000)
NCF		$ 2,531,400	$ 3,081,000	$ 1,857,000	$ 1,090,600	$ 645,000
Terminal value						$ 168,000
b. What are the proposed projects Net Present Value (NPV) and Internal Rate of Return?
NPV =	$ 2,193,449
IRR	29.36%
c. If there are no other project proposals in the firm and you have the money available to fund this project, will you fund the project proposal or not? why?	The firm can fund the project as the NPV is positive.