Problem:
The Wee Willie Windless Windmill Corporation is considering the replacement of a machine that was purchased five years ago for $10,000. At the time of the purchase it was expected to have a useful life of 10 years and no salvage value. Wee Willie has located a smaller firm that would purchase the used machine for $6,000 if Willie decides to buy a new one.
The new machine under consideration will cost $16,000 (including all transportation and installation costs). It is expected to have a useful life of 5 years and a salvage value of $1,000.
The engineering department has estimated that the new machine will reduce annual labor costs by 3,000 and cut the cost of waste materials by $2,000 per year. Also, because it is a new machine, the annual maintenance costs will be $500 per year less than on the old one. Wee Willie uses straight-line depreciation and is in the 40 percent corporate tax bracket. The tax rate applicable to gains and losses on the sale of assets is the same as the corporate tax rate. Willie's WACC is 12 percent.
Q1. Calculate the net initial after-tax cash outlay (ICO) required for this investment?
Q2. Calculate the expected annual incremental after-tax cash flows that will be derived from this investment if Willie decides to go for it?
Q3. Calculate the NPV on this investment? Should Willie go for it? If yes, why? If not, why not? A simple one-sentence explanation will do here.
Q4. Without doing any calculations, is the IRR on this investment higher or lower than 10 percent?
Q5. Now, assume that Wee Willie considers this investment to be more risky than other investments the firm usually makes. (No, I don't know why either, but that's his business). The firm uses RADR to evaluate risky investments. Willie figures an appropriate risk premium for this investment is 5 percent. Does this change the decision in part (c)? If yes, why? If not, why not? Show some figures and briefly explain.