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The Bigbee Bottling Company is contemplating the replacement of one of its bottling machines with a...

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 R600,000 and a remaining useful life of 5 years. The company does not expect to realise any return from scrapping the old machine in 5 years, but it can sell it now to another company in the industry for R265,000. The old machine is being depreciated by R120,000 per year, using the straight-line method. The new machine has a purchase price of R1,175,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of R145,000. The applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected to economise on electric power usage, labour, and repair costs, as well as to reduce the number of defective bottles. In total, an annual savings of R255,000 will be realised if the new machine is installed. The company’s marginal tax rate is 35% and it has a 12% WACC.
23
Required:
4.1 What initial cash outlay is required for the new machine? (3)
4.2 Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made. (5)
4.3 What are the incremental cash flows in Years 1 through 5? (5)
4.4 Should the company purchase the new machine? Support your answer. (3)
4.5 In general, how would each of the following factors affect the investment decision, and how should each be treated?
4.5.1 The expected life of the existing machine decreases. (2)
4.5.2 The WACC is not constant, but is increasing as Bigbee adds more projects into its capital budget for the year. (2)

Solutions

Expert Solution

4.1] Cost of the new machine 1175000
Sale value of the old machine 265000
Book value of the old machine 600000
Loss on sale 335000
Tax shield on loss at 35% 117250
+After tax sale value of the old machine 382250
Initial cash outlay 792750
4.2] 0 1 2 3 4 5 6
Depreciation on new machine 235000 376000 223250 141000 129250 129250
-Depreciation on old machine 120000 120000 120000 120000 120000
Incremental depreciation [change] 115000 256000 103250 21000 9250
4.3] Annual savings 255000 255000 255000 255000 255000
-Incremental depreciation 115000 256000 103250 21000 9250
NOI 140000 -1000 151750 234000 245750
-Tax at 35% 49000 -350 53113 81900 86013
NOPAT 91000 -650 98638 152100 159738
+Incremental depreciation 115000 256000 103250 21000 9250
Incremental operating cash flows 206000 255350 201888 173100 168988
After tax salvage value = 145000-(145000-129250)*35% = 139488
Incremental cash flows 206000 255350 201888 173100 308475
4.4] PVIF at 12% 0.89286 0.79719 0.71178 0.63552 0.56743
PV at 12% 183929 203563 143700 110008 175037
Sum of PVs t1 to t5 816237
Less: Initial outlay 792750
NPV 23487
As the NPV of the replacement is positive, the company should purchase the new machine.
4.5.1] When the expected life decreases, the sum of the PV of the cash inflows would decrease, thereby lowering the NPV.
4.5.2] The discounting rate should be the marginal cost of capital applicable for the funds raised for the project.

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