Top Cat Cannery is considering the replacement of their existing canning machine with a new canning machine.

The old machine has been in use for 3 full years. This particular analysis is, therefore, occurring near the beginning of the old machines fourth physical year. It is classified as a 7-year asset for tax purposes, and has been depreciated using MACRS rates. It cost $50,000 new. It can be used for 4 more years. If the new machine is acquired, the old machine will be sold now. The current fair market value of the old machine is equal to book value.

If the old machine is kept, annual revenue beginning in year 1 of the analysis is expected to be $40,000. Revenues will increase by 5% annually (that is, over the previous years amount). Operating costs are expected to be $10,000 beginning in year 1 of the analysis, and will increase by 10% each year. Four years from now, the old machines fair market value is expected to be $4,600. Assume, if the old machine is used for an additional four years, it will be sold, not donated, at the end of that time.

The new machine has an invoice price of $65,000. Shipping costs (to get the machine to our physical location) are expected to be $2,500, and setup costs will be $5,200. The new machine will be classified as a 7-year asset for tax purposes, and will be depreciated using MACRS rates. Revenues are expected to be $50,000 the first year, and will increase by 5% annually. Operating costs the first year are expected to be $7,500, and will increase by 5% annually.

If the new machine is acquired, the company expects to sell it near the end of the 4^th year of use. Estimated fair market value at that time is $26,000.

The companys tax rate is 22%. Their real discount rate is 6%, and the expected annual rate of inflation over the next four years is 3.78%.

All cash flows are stated in nominal amounts.

1. Calculate Top Cats nominal interest (discount) rate. Round to the nearest whole percent.

2. Using nominal cash flows, calculate the NPV of keeping the old machine. (Hint: there is no Year 0 cash flow.) Round all cash flows to the nearest dollar.

3. Using nominal cash flows, calculate the NPV of buying the new machine. Round all cash flows to the nearest dollar.

4. Which, if either, option should Top Cat select? Why?

Check figures (work done in Excel):

1. 10%

2. $83,829 ; analysis year 4 undiscounted, net of tax cash flow = $30,797

3. $85,325; year 1 depreciation tax shield = $2,286; year 4 undiscounted, net of tax cash flow = $65,649

4. NPV of acquiring new machine is about $1,496 higher than keeping old machine.