In: Finance
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)
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. |