Huawei is considering replacing an existing production line with a new line that has a greater output capacity and operates with less labour than the existing line.
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Existing Production line
The book value is $100,000 and the asset will be depreciated by $20,000 per year for the next 5 years. If you sell the existing production line now, it is expected to be sold for $80,000. Both the book value and market value of the line at the end of year 5 will be zero.
New Production line
The new line would cost $800,000, have a 5-year life, and would be depreciated using the straight-line depreciation method over 5 years. At the end of 5 years, the new line could be sold for $200,000. Because the new line is more automated, it would require fewer operators, resulting in a saving of operating expense of $40,000 per year. Additional sales with the new machine are expected to result in additional net cash inflows of $60,000 per year. The new line is however expected to have a negative impact on other side of the business and an annual operating cost of this side-effect is expected to be $10,000 per year.
If Huawei invests in the new line, a one-time investment of $10,000 in additional working capital will be required. Huawei will get back the additional working capital at the end of year 5. The tax rate is 30 percent, the opportunity cost of capital is 10 percent. What is the NPV of the new production line? Should Huawei take on the new production line?