Island Grills Considering Purchasing a New Machine for $1 Million

question 27

Essay

Island Grills considering purchasing a new machine for $1 million at the end of Year 0 to be put into operation at the beginning of Year 1.The new machine will save $250,000,before taxes,per year from the cash outflows generated by using the old machine.For tax purposes,Island will depreciate the new machine in the following amounts: $100,000 in Year 1,$300,000 in Year 2,and $200,000 per year thereafter until fully depreciated or sold.The new machine will have no salvage value at the end of Year 5.Island expects the new machine to have a market value of $400,000 at the end of three years.If Island acquires the new machine at the end of Year 0,it can sell the old one for $200,000 at that time.The old machine has a tax basis of $300,000 at the end of Year 0.If Island keeps the old machine,the company will depreciate it for tax purposes in the amount of $100,000 per year for three years,when it will have no market value.Island pays taxes at the rate of 40 percent of taxable income and uses a cost of capital of 12 percent in evaluating this possible acquisition.Island has sufficient otherwise-taxable income in Year 0 to save income taxes for each dollar of loss it may incur if it sells the old machine at the end of Year 0.
Required:
a.Compute the net present value of cash flows from each of the alternatives facing Island Grills.
b.Make a recommendation to Island Grills.
c.Assume that the cash flows described in the problem for Years 2 through 5 are real,not nominal,amounts,but the 12 percent cost of capital includes an allowance for inflation of 6 percent.Describe how this will affect your analysis.You need not perform new computations.

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Definitions:

Floatation Costs

The comprehensive expenses involved in releasing new securities, encompassing fees for underwriting, legal services, and registration.

Firm Commitment

An underwriting agreement in which an underwriter agrees to buy all the unsold shares in an initial public offering (IPO).

Underwriter

A person or institution that assesses and accepts the risk on investments, insurance, or securities, often by buying or guaranteeing them.

Direct Costs

Direct costs are expenses directly tied to the production of a product or service, such as raw materials and labor.