Question

2. (13 pts.) A factory is considering replacing its existing coining press with a newer, more efficient one. The existing press was purchased 4 years ago for $450,000 and is being depreciated according to a 7-year MACRS depreciation schedule. (See page 4 for the MACRS schedules.) The factory’s CFO estimates that the existing press has 5 years of useful life remaining. The new press’s purchase price is $560,000. Installation of the new press would cost an additional $40,000; this installation cost would be added to the depreciable base (i.e., it would be capitalized) and then depreciated across time. The new press (if purchased) would be depreciated using the 7-year MACRS schedule although the factory
Assignment 3, p.2
(2, continued) will retire or sell the new press after 5 years. Interest expenses associated with the purchase of the new press are estimated to be roughly $8000 per year for the next 5 years. If the new press is purchased, revenues will remain the same as they’d be if the old press were maintained. However, the appeal of the new press is that it will reduce production costs by $153,000/year for the next 5 years. Also, if the new press is purchased, the old press can be sold for $60,000 today. The CFO believes that the new press would be sold for $90000 in 5 years; the old press’s value at t=5 will be $0. NWC would not be affected. The company’s marginal tax rate = 34.0%. The cost of capital (i.e., the required rate of return) for this project is 7.5% (although this variable is not needed in this problem, given the instructions below)

Calculate the incremental cash flows for this replacement decision, for time 0, for each year of operation, and at termination. Please make sure that you show clear work as to determine how you arrived at your incremental cash flows! [Hint: The old press’s net book val. at t=0 is $140,580. Hint: I want to remove any doubts surrounding the depreciation schedule for the old machine. Yes, if kept in place, the existing machine will reach a book value of $0 before the machine is retired. Many long-term assets are still functional after they’re fully depreciated.] [Note: Normally, you would then use these cash flows to calculate NPV and IRR of the incremental decision to either (1) buy the new press and sell the old one or (2) keep the old press. Next, you would make a conclusion about whether or not the existing coining press should be replaced at this time. However, this assignment already contains an adequate number of other NPV and IRR calculations.]

Answer 1

Year	0	1	2	3	4	5	6	7	8
Purchase price of new m/c	-560000
Installation expenses	-40000
AT cash flow on sale of Old m/c	87397
AT cash flow on sale of new m/c						104912
Incremental tax -cash outflow savings due to interest exp.(8000*34%)		2720	2720	2720	2720	2720
Incl.after-tax savings in prodn.costs(153000*(1-34%))		100980	100980	100980	100980	100980
Depn. Tax shields lost on old m/c(8.93,8.92,8.93& 4.46%*450000*34%)		-13663	-13648	-13663	-6824
Depn. Tax shields available on new m/c(14.29,24.49,17.49,12.49& 8.93%*600000*34%)		29152	49960	35680	25480	18217	-18197	-18217	-9098
Total annual incremental cash flows	-512603	119189	140012	125717	122356	226829	-18197	-18217	-9098
PV F at 7.5%(1/1.075^Yr.n)	1	0.93023	0.86533	0.80496	0.74880	0.69656	0.64796	0.60275	0.56070
PV at 7.5%	-512603	110873	121157	101197	91620	157999.8	-11791	-10981	-5101
NPV of the incremental cash flows	42371
Replacement is recommended as the NPV of the Incremental cash flows is POSITIVE.
NOTE:
As the factory will retire or sell the new press after 5 years, depn. Tax shields that will be lost in Yrs. 6, 7 & 8 also has been taken as loss of cash value (for tax expense)
Workings:
Old m/c salvage at Yr. 0
Book Value	140580
Sale value	60000
Loss on sale	80580
Tax saved on loss	27397
AT cash flow on sale(60000+27397)	87397
New m/c sale at YR. 5
Book Value(600000*22.31%)	133860
Sale value	90000
Loss on sale	43860
Tax saved on loss	14912
AT cash flow on sale(90000+14912)	104912