Case Scenario:
Joe and Mary are a married couple who own their own business. Over the past several years they have grown their business from an idea that they had into a successful moneymaker. When the couple began their business they did not have a great deal of capital to invest in it and as a result some of the equipment that they purchased was only useful to them in the short run. One such piece of equipment is the DLT-35 machine used to make their primary product. The DLT-35 machine that they have is still in good working order but can not produce the volume that is needed to match sales. In addition the model of the machine that they have is more expensive to operate than newer models of the machine because it is less efficient then they are. This machine was originally purchased for $500,000 and has incurred $275,000 in depreciation.
After lengthy consideration the couple decided to replace the DLT-35 machine. They have done some research for this expenditure and found that they could purchase either one of two machines. Both machines are sold by the same dealer who has offered them $750,000 in trade-in value on the current DLT-35 machine. The dealer also has a special promotion going on that waives all installation costs for either machine. The first option, option 1, is to buy a DLT-1000 machine. The DLT-1000 has a sales price of $2 million. This machine is an updated version of the one that they have. Although the machine is similar it is believed that Joe and Mary’s employees will have difficulty using the machine at first. The manufacturer has guaranteed that this machine will increase Joe and Mary’s EBTD by $100,000 in the first year, $125,000 in the second year, $250,000 in the third year, $500,000 in the fourth year and $500,000 in the fifth year. At the end of the five years the machine will no longer be suitable for Joe and Mary’s purposes and therefore sold. The DLT-1000 has an expected salvage value of $375,000 five years from now.
The alternative to option 1, option 2, is to purchase a slightly more expensive machine the ELF-29. The ELF-29 is the state of the art machine used for making Joe and Mary’s product. The ELF-29 has a sales price of $2.5 million. The manufacturer of the ELF-29 has also guaranteed Joe and Mary that the machine will increase their EBTD. This machines increase will be a constant $400,000 increase each year for five years. Like with the DLT-1000 the ELF-29 will no longer be useful to Joe and Mary after five years and they would need to sell it. The RCR-29 has an expected salvage value of $500,000 five years from now.
The couple was not sure which machine that they should buy. Their instincts told them that the DLT-1000 machine was preferable because they had to invest less capital to acquire the machine initially and at the same time it yielded higher earnings the last two years of operation. Joe and Mary are puzzled however; they went to their accountant Bob to ask his opinion on the situation. Bob told them that it was not a good idea to base their comparison only on the future values of the cash flows involved in the problem. He recommended that they take the present value of all of the cash flows involved and assess the two investments on that basis. The couple agreed with Bob and decided to evaluate the two alternatives by; calculating the net investment for each machine, estimating the discounted present value of cash flows that each machine will yield and then find the net present value of each investment.
Based on the above case, answer the following questions. Assume that the couple currently has sufficient capital to purchase either piece of equipment. The couple’s business is in the 35% ordinary tax bracket and the 20% capital gains tax bracket. They have a cost of capital of 8%. Both machines are depreciated over the 5-year period using straight-line depreciation.
Q1. Find the Net Investment for both options. Which option is more attractive based solely on this evaluation?
Q2. Calculate the Net Cash Flows for both options. Which option is more attractive based solely on this evaluation?
Q3. Briefly explain the reasons for any difference in your answer in question 1 and question 2 or why both support the same option.
Q4. Find the Net Present Value of each investment.
Q5. Which investment would Bob most likely recommend given his recommendation to use the Net Present Value method? Why?
Q6. Why would Bob tell Joe and Mary not to base their comparison on the future values of the cash flows, as they were intuitively doing before they went to see him?