Question

REPLACEMENT ANALYSIS

The Bigbee Bottling Company is contemplating the replacement of one of its bottling machines with a newer and more efficient one. The old machine has a book value of $600,000 and a remaining useful life of 5 years. The firm does not expect to realize any return from scrapping the old machine in 5 years, but it can sell it now to another firm in the industry for $295,000. The old machine is being depreciated by $120,000 per year, using the straight-line method.

The new machine has a purchase price of $1,100,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $150,000. The applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected to economize on electric power usage, labor, and repair costs, as well as to reduce the number of defective bottles. In total, an annual savings of $225,000 will be realized if the new machine is installed. The company's marginal tax rate is 35%, and it has a 12% WACC.

1. What initial cash outlay is required for the new machine? Round your answer to the nearest dollar. Negative amount should be indicated by a minus sign.
   $
   
2. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made. Round your answers to the nearest dollar.

   Year	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation
   1	$	$	$
   2
   3
   4
   5

3. What are the incremental net cash flows in Years 1 through 5? Round your answers to the nearest dollar.

   Year 1	Year 2	Year 3	Year 4	Year 5
   $	$	$	$	$

4. Should the firm purchase the new machine?
   -Select-YesNoItem 22
   
   Support your answer. The input in the box below will not be graded, but may be reviewed and considered by your instructor.
   
5. In general, how would each of the following factors affect the investment decision, and how should each be treated?
   1. The expected life of the existing machine decreases.

   The input in the box below will not be graded, but may be reviewed and considered by your instructor.

   2. The WACC is not constant, but is increasing as Bigbee adds more projects into its capital budget for the year.

   The input in the box below will not be graded, but may be reviewed and considered by your instructor.

Answer 1

Part a:
Net Cashflow if new machine is purchased and old machine is replaced
Tax credit on sale of old machine = (Book value - sale value) * tax rate = ($600,000 - $295,000)*35% = $106,750
After tax sale value of Old Machine = Sale Value + Tax credit = $295,000 + $106,750 = $411,750
Purchase of New machine = $1,100,000
Less: After tax Sale Value = ($411,750)
Net Initial Cash Outflow    = $688,250
Part b:
Computation of Incremental Annual Depreciation Expense
Year	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation
1	220000	120000	100000
2	352000	120000	232000
3	209000	120000	89000
4	132000	120000	12000
5	121000	120000	1000

Part (c ):
Calculation of Incremental Net Cashflows
Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Operating Cash Flows
Annual Pre tax Savings (A)	225000	225000	225000	225000	225000
Less: incremental Depreciation (B)	100000	232000	89000	12000	1000
Profit Before Tax (C = A-B)	125000	-7000	136000	213000	224000
Less: Tax @35% (D = C*35%)	43750	-2450	47600	74550	78400
Profit After Tax (E = C-D)	81250	-4550	88400	138450	145600
Addback Depreciation (F = B)	100000	232000	89000	12000	1000
Net Operating Cashflows (G = E+F)	181250	227450	177400	150450	146600
Additional Cashflows in Year 5
Salvage value (H)					155000
Less: Depreciation (I) ($1,100,000 *6%)					66000
Net Salvage Value (J = H-I)					89000
Less: Tax @35% (K = J*35%)					31150
Profit After Tax (L = J-K)					57850
Addback Depreciation (M = I)					66000
Net Salvage Value after tax (N = L+M)					123850
Total Cashflows (O = G+N)	181250	227450	177400	150450	270450

v

Part (d):
Calculation of NPV of the Project
Year	Cashflows	Discount Rate @12%	Discounted Cashflows
A	B	C = 1/(1+12%)^A	D = B*C
0	-688250	1	-688250
1	181250	0.892857143	161830.3571
2	227450	0.797193878	181321.7474
3	177400	0.711780248	126269.816
4	150450	0.635518078	95613.6949
5	270450	0.567426856	153460.5931
Net Present Value of Machine			30246.20858
NPV = $30,246.21
The firm should purchase the machine since NPV > 0

Question e:

The factor affective the decision is if the useful life of existing machine decrease