Question

1. ABC Company is thinking of replacing of one of its machines with a newer one. The old machine has a book value of $610,000 and a remaining useful life of 5 years and it can be sold to another firm in the industry for $255,000. The old machine is being depreciated by $120,000 per year, using the straight-line method. The new machine has a purchase price of $1,175,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $155,000. The applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected to economize on electric power usage, labour, and repair costs, as well as to reduce the number of defective bottles. In total, an annual savings of $265,000 will be realized if the new machine is installed. The company's marginal tax rate is 40% and it has a 15% WACC.
a. What initial cash outlay is required for the new machine?
b. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made.
c. What are the incremental cash flows in Years 1 through 5?
d. Should the firm purchase the new machine? Support your answer.

Solve using a financial calculator. Do it Manually. ( Do not use on excel)

Answer 1

Part a) Initial cash outlay = purchase price of new machine-Sale value of old machine = $1,175,000-$255,000 = $920,000

Part b) Annual depreciation allowance for new machine = (Cost-Salvage value)*depreciation rate
Year 1 = (1175000-155000)*20% = 1020000*20% = $204,000; Year 2 = 1,020,000*32% = 326,400; Year 3 = 1,020,000 *19% = 193,800; Year 4 = 1,020,000*12% = 122,400; Year 5 = 1,020,000*11% = 112,200
Annual depreciation allowance for old machine = 120,000

Year	1	2	3	4	5
Depreciation on new machine	204,000	326,400	193,800	122,400	112,200
Depreciation on old machine	120,000	120,000	120,000	120,000	120,000
Change in depreciation	84,000	206,400	73,800	2,400	-7,800

Part c)

Sl No	Year	1	2	3	4	5
i	Annual savings (given)	265,000	265,000	265,000	265,000	265,000
ii	Change in depreciation (refer part b)	84,000	206,400	73,800	2,400	-7,800
iii	Savings before tax (i-ii)	181,000	58,600	191,200	262,600	272,800
iv	Tax @ 40% (iii*40%)	72,400	23,440	76,480	105,040	109,120
v	Net savings (ii-iv)	108,600	35,160	114,720	157,560	163,680
vi	Add back: Change in depreciation (ii)	84,000	206,400	73,800	2,400	-7,800
vii	Sale of new machine (Given)					155,000
viii	Incremental cashflow (v+vi+vii)	192,600	241,560	188,520	159,960	310,880

Part d)

Sl No	Year	0	1	2	3	4	5
i	Incremental cashflow (refer part c)	0	192,600	241,560	188,520	159,960	310,880
ii	Initial cash outlay (refer part a)	-920,000
iii	Net cashflow (i+ii)	-920,000	192,600	241,560	188,520	159,960	310,880
iv	PVF @ 15%	1	0.8696	0.7562	0.6576	0.5718	0.4972
v	Present value of cashflow (iii*iv)	-920,000	167,485	182,668	123,971	91,465	154,570

NPV = ΣPresent value of cash flow = -199,842
Since replacement of old machine by new machine gives negative NPV, so the firm should not purchase the new machine.