Drake Enterprises is a publicly traded firm that manufacture

Drake Enterprises is a publicly traded firm that manufactures panels for vans. The business is profitable and demand has been increasing. One of the main machines at the company is dated and the company is evaluating whether to replace it. The new machine would cost $750,000 to purchase plus $90,000 in installation and shipping costs. The machine would have a useful life of six years and would be depreciated down to zero on a straight line basis. As a result of the new machine, revenues will increase by $185,000 per year over its six year life, and the machine will also produce cost savings of $95,000 per year. There will be extra inventory needed for the new machine; this is expected to be $60,000. Accounts payable will increase as a result of the new machine as will accounts receivable, by $40,000 and $50,000 respectively. These figures are expected to remain constant until the end of the project. The new machine will require the use of an extra storage garage; the firm has an extra garage but it is being rented out at the moment for $50,000 a year, but would become used by the project if the project was adopted. The machine will require a full maintenance overhaul at the end of three years; this is expected to cost $50,000. A mechanic that already works for the company will be assigned to maintain the new machine; his salary is $30,000 a year. The company will have to hire someone to replace the mechanic. The old machine, which has a book value of $150,000 and three years of life left, will be sold if the project is accepted for $100,000. It is expected that the new machine will be sold at the end of the project for $60,000. The company faces a tax rate of 30% and a cost of capital of 12%. Calculate the breakeven point, NPV, and IRR. Should Drake Enterprises buy the new machine?

Solution

The answers to the following parts as follows:

Calculation of the NPV :

i) Statement of Cash Outflows

a .Cost of the new machine =$750000 + cost of installation and shipping $90000 =$890000

       Less :Sale value of the old machine                                                           =$100000

       Less :Tax savings from sale of loss of sale of old machine @30%*(150000-100000) =$15000

                                   Net Cash Outflow                                                                   =$740000

b. Statement of Cash Inflows

   Particulars                                             Amount Before Tax                                          Amount After Tax

Cost Savings                                             $95000                                                           $66500

Extra inventory                                            $60000                                                           $42000

Extra Inflow due to Netting of Accounts Receivable and Payable $10000                                 $7000

Extra Inflow for the rented out storage garage which is now rented out $50000                         $35000

Full Maintenance Charge                                                                  $ 50000                       $35000

Mechanic Salary                                                                              $ 30000                       $21000

Depreciation :

     New Machine                        $ 0

     Old Machine                          ($150000-$100000)/3=$16667                                             $16667

                         $27167

iii) statement of NPV

Present value of cash inflow for 6 years @ 12 % ie 4.1111 * 27167 =$111686

Less PV of cash outflow $ 740000*1 =$740000

   NPV     $(628316)

Since the NPV is negative Drake should not purchase the machine.

Calculation of Break Even Point

Break even point =Fixed Cost/(Sales -Variable Cost)

      Fixed Cost is nothing but the full maintenance charge plus the extra inventory cost

   =$60000+$50000

   =$110000

Sales -Variable cost = Cost Savings for the year           

                              = $95000

Break Even Point =$110000/$95000

                            =1.15