Problem: Theta Widgets Inc. is known for manufacturing some of the highest quality widgets in the country. One of the machines that Theta uses may need replacement. The following information is available to you:
- Revenues will not change if the machine is replaced.
- The present 'old' machine has a 'book value' of $50,000.
- The new machine will last 5 years and will have no disposal value in five years.
- The new machine will cost $1,750,000. It can be depreciated for tax purposes over a period of 5 years.
- If the new machine is purchased, the old machine will be disposed of right now for a disposal value of $200,000. The difference between the proceeds from the sale of the old machine and its 'book value' is taxable at Theta Widgets Inc. corporate tax rate of 34% (T = 0.34).
- The new machine will reduce operating costs by $490,000 per year (assume cash flows at the end of the years). Note that these annual cost savings are effectively taxable.
Assume that the Theta's Weighted Average Cost of Capital (WACC) is 7.25%.
Part 1: Construct the cash flow of the proposed investment. Then compute the net present value of the proposed investment using Theta's weighted average cost of capital. Write a short report to management stating whether the new machine should or should not be purchased.
Once done, check what is the NPV of the proposed project if Theta's WACC is:
(a) 2% ; (b) 4% ; (c) 6% ; (d) 8% ; (e) 10% ; (f) 12%
Write a paragraph explaining what general conclusions you derive from the results of your repeated computations.