La Familia Company limited is considering the purchase a high speed drill to replace the old one that they currently have.
The old drill was purchase 3 years ago at an installed cost of $500,000 and is estimated to have a usable life of 5 years.
The new drill is expected to cost $850,000 with $20,000 to be spent on installation and also has a 5 year usable life.
La Familia can sell the old drill at $60,000 inclusive of removal cost.
The purchase of this new drill will result in increase business and impact on the following:
- Accounts Receivable increase by $55,000
- Inventories by $25,000
- Accounts payable by $42,000
At the end of the 5 years the new drill will have a residual value of $50,000 and should be sold for that amount.
La Familia funds it assets as follows:
Long term Bonds 25%
Preferred stock25%
Common stock50%
The interest on the bonds is 8%. The preferred stock pays dividends of 10%. The risk free rate is 4%, the beta on La Familia's stock is 1.2 and the market risk premium is 8%.
La Familia tax rate is 25%
Straight line method of depreciation applies.
Earnings before depreciation and taxes are as follows:
|
Year
|
New Drill
|
Old Drill
|
|
1
|
$125,000
|
$35,000
|
|
2
|
$250,000
|
$30,000
|
|
3
|
$275,000
|
$28,000
|
|
4
|
$275,000
|
$22,000
|
|
5
|
$175,000
|
$10,000
|
|
|
|
- Calculate the initial Investment for the replacement of the old drill with the new drill.
- Calculate the incremental operating cash flows that is expected from the purchase of the new drill.
- What is the terminal cash flow at the end of year 5 due to the replacement of the old drill with the new one.
- Should the new drill be purchased based on NPV analysis and IRR?
- What other factors need to be consider before the decision to replace the old machine is made.