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:

Gain From Trade

The increase in utility or benefit that entities receive from trading goods or services with each other, often as a result of specialization and efficiency.

Barrels

A unit of measure for oil and other petroleum products, equal to 42 US gallons.

Absolute Advantage

The ability of an individual, company, or country to produce a good or service at a lower cost per unit than the cost at which any other entity produces that good or service.

Production Possibility Frontiers

A curve depicting all maximum output possibilities for two or more goods, given a set of inputs.