Lynch Castings is planning to replace a continuous casting machine with a newer and more efficient model. The existing model was purchased 5 years ago and cost £20000. It had an expected life of 10 years and salvage value of £4000. However, reliability has become a problem and replacement parts are costing the company £2000 a year. The market for continuous casting machines is currently somewhat flat. The distributors of the best known model currently available are keen to boost turnover and have offered to sell the company a new machine at a large discount to the list price. The price quoted by the distributors is £18000 for cash. The distributors are prepared to buy the old machine from the company for £6000 and claim that the new machine will require no maintenance, will last without problem for five years and they guarantee to buy it back at that time for £2000. The new machine will result in cost savings of £7000 per year but will require additional working capital of £5000 which will be recoverable in five years time. Lynch Castings employs straight line depreciation. The old machine is being depreciated over ten years, the new machine would be depreciated over 5 years. The opportunity cost of capital is 12% and the marginal tax rate is 25%. Depreciation is not allowable as a deduction for tax purposes. c) Calculate the NPV from replacing the machine

Principles of Accounting Volume 2

19th Edition

ISBN:9781947172609

Author:OpenStax

Publisher:OpenStax

Chapter10: Short-term Decision Making

Section: Chapter Questions

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Lynch Castings is planning to replace a continuous casting machine with a newer and more efficient model. The existing model was purchased 5 years ago and cost £20000. It had an expected life of 10 years and salvage value of £4000. However, reliability has become a problem and replacement parts are costing the company £2000 a year. The market for continuous casting machines is currently somewhat flat. The distributors of the best known model currently available are keen to boost turnover and have offered to sell the company a new machine at a large discount to the list price. The price quoted by the distributors is £18000 for cash. The distributors are prepared to buy the old machine from the company for

£6000 and claim that the new machine will require no maintenance, will last without problem for five years and they guarantee to buy it back at that time for £2000. The new machine will result in cost savings of £7000 per year but will require additional working capital of £5000 which will be recoverable in five years time. Lynch Castings employs straight line depreciation. The old machine is being depreciated over ten years, the new machine would be depreciated over 5 years. The opportunity cost of capital is 12% and the marginal tax rate is 25%. Depreciation is not allowable as a deduction for tax purposes.

c) Calculate the NPV from replacing the machine

Expert Solution

Step 1

Net present value (NPV) is computed by subtracting present value of cash outflows from the present value of cash inflows. Present value of cash inflows and outflows are obtained by discounting the cash flows by an appropriate discount rate.

Step 2

After tax cash flows can be calculated as follows:

For Year 0,

$C a s h o u t l a y = P u r c h a s e p r i c e - R e c o v e r y p r i c e + W o r k i n g c a p i t a l C a s h o u t l a y = (18, 000 - 6, 000 + 5, 000) P o u n d s C a s h o u t l a y = 17, 000 P o u n d s$

For Year 5,

$C a s h i n f l o w = (C o s t s a v i n g s + S a l v a g e v a l u e) \times (1 - T a x r a t e) + W o r k i n g c a p i t a l C a s h i n f l o w = (7, 000 + 2, 000) \times (1 - 0.25) + 5, 000 C a s h i n f l o w = 11, 750 P o u n d s$

Note: As it is mentioned that depreciation will not be considered for tax purpose, therefore, it will not impact the calculation of cash flows.

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