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Chapter 06 - Making Capital Investment Decisions
There is another way to analyze a replacement decision that is often used. It is an incremental cash flow analysis of the change in cash flows from the existing machine to the new machine, assuming the new machine is purchased. In this type of analysis, the initial cash outlay would be the cost of the new machine, the increased NWC, and the cash inflow (including any applicable taxes) of selling the old machine. In this case, the initial cash flow under this method would be:
Purchase new machine Net working capital Sell old machine
Taxes on old machine Total
–$18,000,000
–250,000 4,500,000 585,000 –$13,165,000
The cash flows from purchasing the new machine would be the saved operating expenses. We would also need to include the change in depreciation. The old machine has a depreciation of $1.5 million per year, and the new machine has a depreciation of $4.5 million per year, so the increased depreciation will be $3 million per year. The pro forma income statement and operating cash flow under this approach will be:
Operating expense savings Depreciation EBT Taxes
Net income OCF
The NPV under this method is:
NPV = –$13,165,000 + $5,257,000(PVIFA10%,4) + $250,000 / 1.104 NPV = $3,669,736.02 And the IRR is:
0 = –$13,165,000 + $5,257,000(PVIFAIRR,4) + $250,000 / (1 + IRR)4 Using a spreadsheet or financial calculator, we find the IRR is: IRR = 22.23%
So, this analysis still tells us the company should purchase the new machine. This is really the same type of analysis we originally did. Consider this: Subtract the NPV of the decision to keep the old machine