Question

In: Finance

A company is considering replacing one of the old machines used in the manufacturing process. The...

A company is considering replacing one of the old machines used in the manufacturing process. The machine was purchased 2 years ago for $600,000. This machine is being depreciated on a straight-line basis, and it has 4 years of remaining life. When this machine was purchased 2 years ago, it was assumed to have zero salvage value at the end of its useful life of 6 years. Currently, this machine has a market value of $250,000. The company intends to keep this old machine as spare if the replacement happens. The current revenue generated by this machine is $250,000 annually and the cost of operating the machine is $175,000 annually.

The replacement machine will cost of $750,000 and $50,000 for shipping and transportation to the company’s location. The new machine falls into 3-year MACRS (33%, 45%, 15% and 7%). The replacement machine would permit an output expansion, so sales will become $450,000 per year. Even so, the new machine's greater efficiency would cause operating expenses to become $95,000 per year. The new machine would require inventories be increased by $65,000, but accounts payable would simultaneously increase by $10,000. The replacement project life is 4 years. The new machine can be sold at the end of the project’s life for $50,000 while the old machine will not have any value at the end of the 4th year. The company’s marginal federal-plus-state tax rate is 40%, and its cost of capital is 12%.

What is cash flow CF1 to be used in NPV calculations?

287,600

233,600

228,300

246,800

212,400

Solutions

Expert Solution

Cost of old machine 2 year ago = $600,000, Salvage value of old machine in 4 years = 0, Depreciable life of old machine = 6 years

Since old machine will be depreciated according to straight line method

Old machine Depreciation for year 1 = (Cost of old machine 2 year ago - Salvage value of old machine in 4 years) / Depreciable life of old machine = (600000 - 0) / 6 = 600000 = 100000

Total cost of replacement machine or new machine = Cost of machine + shipping & transportation charges = $750000 + 50000 = 800000

Depreciation under MACRS = rate of depreciation x total cost of machine

New machine Depreciation for year 1 under 3 year MACRS = rate of depreciation for year 1 under 3 year MACRS x total cost of new machine = 33% x 800000 = 264000

Incremental depreciation = New machine Depreciation for year 1 - Old machine Depreciation for year 1 = 264000 - 100000 = 164000

Incremental Revenue for year 1 = Revenue from new machine - Revenue from old machine = 450000 - 250000 = 200000

Incremental operating costs for year 1 = Operating costs of new machine - Operating cost of old machine = 95000 - 175000 = - 80000

Cash flow in year 1 for NPV will only consist of After operating cash flow

After tax operating cash flow for year 1 = (Incremental revenue - incremental operating costs - incremental depreciation)(1-tax rate) + incremental depreciation = [200000 - (-80000) - 164000][1-40%] + 164000 =[200000 + 80000 - 164000][1-40%] + 164000 = 116000 x 60% + 164000 = 69600 + 164000 = 233600

Hence CF1 = Cash flow in year 1 for NPV = 233600

Answer: 233600


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