Replacing a Small Machine: Capital-Budgeting Techniques and Sensitivity Analysis Hightec Corporation has a seven-year contract with Magichip Company to supply 10,000 units of XT-12 at $5 per unit. Increases in materials and other costs since signing the contract two years ago make this product a cash drain to Hightec. As the manager of the subsidiary that manufactures and sells XT-12, you have discovered that a new machine, SP1000, has a higher productivity. The following is a summary of pertinent information:
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Machine in Use
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SP1000
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Capacity
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10,000 units/year
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18,000 units/year
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Materials
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$4.00 per unit
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$3.00 per unit
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Labor and other variable costs
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$1.00 per unit
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$0.20 per unit
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Maintenance costs
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$1.00 per unit
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$0.10 per unit
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(For simplicity, assume that all revenues and expenses are received and paid at year-end.)
The current machine can be sold for $3,000 today. Its salvage value will be $1,000 if the firm continues to use the machine for another five years. The new machine costs $100,000, will be depre- ciated over a five-year life, and will have a net disposal value of $5,000 in five years. The company's after-tax cost of capital is 10 percent. If the company decides to keep the old machine, which is fully depreciated, production can continue with it for at least another five years. All machines are depreciated on a straight-line basis with no salvage value. (Assume, for simplicity, that MACRS depreciation rules do not apply.) The firm expects to continue to pay approximately 20 percent for both federal and state income taxes in the foreseeable future. At present the Magichip Company is the only user of XT-12.
Required Compute:
1. The effects on the cash flow each year, including year 0, if the new machine is purchased.
2. The net present value (NPV) of the new machine.
3. The payback period of the new machine, under the assumption that cash inflows occur evenly through- out the year.
4. The internal rate of return (IRR) on the new machine, assuming that the new machine's annual cash inflows are $25,000 and that neither the new machine nor the existing machine will have salvage value at the end of the five-year period.
5. The internal rate of return (IRR) assuming that the after-tax cash inflows are as follows and that the estimated salvage value for both machines at the end of five years is $0.
Year 1 $20,000
Year 2 22,000
Year 3 25,000
Year 4 30,000
Year 5 40,000
6. By how much can the variable costs of the new machine increase (or decrease) and the company be indifferent on the replacement, assuming all the other costs will be as estimated?