Erwin DeLavall, the Plant Manager of Patch Grove Cabinets, is trying to decide whether or not to replace the old manual lathe machine with a new computerized lathe. He thinks the new machine will add value, but is not sure how to quantify his opinion. He asks his colleague, Terri Wharten, for advice. Wharten‘s son just happens to be a Level II CFA candidate. DeLavall and Wharten provide the following information to Wharten’s son: Company Assumptions: New Machine Assumptions: Cost of (includes shipping and installation): $90,000 Salvage value at end of year 5: $15,000 Depreciation Schedule: MACRS 7year, with depreciation rates in years 15 of 14%, 25%, 17%, 13%, and 9%, respectively Purchase will initially increase current assets by $20,000 and will increase current liabilities by $25,000 Impact on Operating Cash Flows Years 1 5 (includes depreciation and taxes): $16,800 (assume equal amount each year for simplicity)
Old Machine Assumptions: Current Value: $30,000 Book value: $13,000
Which of the following choices is most correct? Patch Grove Cabinets should: A)
 replace the old lathe with the new lathe because the new one will add $3,760 to the firm's value. 
 B)
 replace the old lathe with the new lathe because the new one will add $10,316 to the firm's value. 
 C)
 not replace the old lathe with the new lathe because the new one will decrease the firm's value by $5,370. 

The valuation method that shows the project’s impact on the value of the firm is net present value (NPV). To calculate NPV, we need to determine the initial investment outlay, the operating cash flows, and the terminal year cash flows. Then, we discount the cash flows at the WACC. The calculations are as follows: Step 1: Initial Investment Outlay: = cost of new machine + proceeds/loss from old machine + change in net working capital (NWC) = $90,000 + $30,000  $6,800 + $5,000 = $61,800 (cash outflow) Details of calculation: ·
Cost of new lathe = $90,000 outflow ·
Sale of Old Machine: o
Sales price = $30,000 inflow o
Tax/tax credit: $6,800 outflow §
= (Sales price – book value)*(tax rate) = (30,000 – 13,000)*0.4 ·
Change in NWC = $5,000 inflow o
DNWC = D current assets  D current liabilities = 20,000 – 25,000 = 5,000 (a decrease in working capital is a source of funds) Step 2: Operating Cash Flows (years 14): Given as $16,800 inflow Step 3: Terminal Value: = year 5 cash flow + return/use of NWC + proceeds/loss from disposal of new machine + tax/tax credit = $16,800  $5,000 + $15,000 + $1,920 = $28,720 inflow Details of calculation: ·
Year 5 cash flow (given) = $16,800 inflow ·
Working capital (reverse 5,000 initial inflow) = $5,000 outflow ·
Sale of New Lathe: o
Sales price = $15,000 inflow o
Tax/tax credit: $1,920 inflow §
= (Sales price – book value)*(tax rate) §
Here, the Book value = Purchase price – depreciated amount. Using MACRS we have depreciated 78% of the value, or have 22% remaining. 0.22 * 90,000 = 19,800 §
Tax effect = (15,000 – 19,800)*(0.4) = 1,920, or a tax credit Step 4: Calculate NPV: NPV = $61,800 + ($16,800 / 1.131) + ($16,800 / 1.132) +($16,800 / 1.133) +($16,800 / 1.134) +($28,720 / 1.135) = $3,759. Since the NPV is positive, Patch Grove should replace the old lathe with the new one, because the new lathe will increase the firm’s value by the amount of the NPV, or $3,759.
You may also solve this problem quickly by using the cash flow (CF) key on your calculator.[/table][table=98%]
Calculating NPVA with the HP12C®
Key Strokes Explanation Display
[f]→[FIN]→[f]→[REG] Clear Memory Registers 0.00000
[f]→[5] Display 5 decimals – you only need to do this once. 0.00000
61,800→[CHS]→[g]→[CF0] Initial Cash Outlay 61,800.00000
16,800→[g]→[CFj] Period 1 Cash flow 16,800.00000
4→[g]→[Nj] Cash Flow Occurs for 4 periods 4.00000
28,720→[g]→[CFj] Period 5 Cash flow 28,720.00000
13→ WACC 13.00000
[f]→[NPV] Calculate NPV 3,759.18363
Calculating NPVA with the TI Business Analyst II Plus→  Key Strokes  Explanation  Display  [2nd]→[Format]→[5]→[ENTER]  Display 5 decimals – you only need to do this once.  DEC= 5.00000  [CF]→[2nd]→[CLR WORK]  Clear Memory Registers  CF0 = 0.00000  61,800®[+/]→[ENTER]  Initial Cash Outlay  CF0 = 61,800.00000  [↓]→16,800→[ENTER]  Period 1 Cash Flow  C01 = 16,800.00000  [↓] 4 [ENTER]  Frequency of Cash Flow 1  F01 = 4.00000  [↓]→28,720→[ENTER]  Period 2 Cash Flow  C02 = 28,720.00000  [↓]  Frequency of Cash Flow 2  F02 = 1.00000  [NPV]→13→[ENTER]  WACC  I = 13.00000  [↓]→[CPT]  Calculate NPV  NPV = 3,759.18363 
