Question
(CMA, adapted) The Frooty Company is a family-owned business that produces fruit jam. The company has a grinding machine that has been in use for
(CMA, adapted) The Frooty Company is a family-owned business that produces fruit jam. The company has a grinding machine that has been in use for 3 years. On January 1, 2014, Frooty is considering the purchase of a new grinding machine. Frooty has two options: (1) continue using the old machine or (2) sell the old machine and purchase a new machine. The seller of the new machine isnt offering a trade-in. The following information has been obtained:
Frooty is subject to a 34% income tax rate. Assume that any gain or loss on the sale of machines is treated as an ordinary tax item and will affect the taxes paid by Frooty in the year in which it occurs. Frootys after-tax required rate of return is 12%. Assume all cash flows occur at year-end except for initial investment amounts.
Required:
1. A manager at Frooty asks you whether it should buy the new machine. To help in your analysis, calculate the following:
a. One-time after-tax cash effect of disposing of the old machine on January 1, 2014
b. The after-tax cash operating costs of keeping the old machine, of buying the new machine, and the difference between the two values (variable and fixed).
c. The total difference between the depreciation tax shield (DTS) resulting from keeping the old machine and buying the new machine.
d. Difference in after-tax cash flow from the terminal disposal of new machine and old machine
2.Use the net present value method to determine whether Frooty should use the old machine or acquire the new machine. Calculate the NPV of each option the way it was done in class. Check the NPV calculations using the NPV function in Excel.
3. How much more or less would the recurring after-tax cash operating savings of the new machine need to be for Frooty to be indifferent about whether to keep the old machine or buy the new machine? Assume that all other data about the investment do not change
Answer questions 1 through 3
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