Question

The Dauten Toy Corporation uses an injection molding machine that was purchased prior to the new tax legislation. This machine is being depreciated on a straight-line basis, and it has 6 years of remaining life. Its current book value is $2,100, and it can be sold for $2,500 at this time. Thus, the annual depreciation expense is $2,100/6 = $350 per year. If the old machine is not replaced, it can be sold for $500 at the end of its useful life.

Dauten is offered a replacement machine which has a cost of $8,000, an estimated useful life of 6 years, and an estimated salvage value of $800. The replacement machine is eligible for 100% bonus depreciation at the time of purchase. The replacement machine would permit an output expansion, so sales would rise by $1,000 per year; even so, the new machine's much greater efficiency would cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,500, but accounts payable would simultaneously increase by $800. Dauten's marginal federal-plus-state tax rate is 25%, and its WACC is 11%.

What is the NPV of the incremental cash flow stream? Negative value, if any, should be indicated by a minus sign. Round your answer to the nearest cent.
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Answer 1

ANSWER

Time line		0	1	2	3	4	5	6
Proceeds from sale of existing asset	=selling price* ( 1 -tax rate)	1950
Tax shield on existing asset book value	=Book value * tax rate	525
Cost of new machine		-8000
Initial working capital		1700
=Initial Investment outlay		-3825
									100.00%
Savings			2500	2500	2500	2500	2500	2500
-Depreciation			-8000	0	0	0	0	0	0	=Salvage Value
=Pretax cash flows			-5500	2500	2500	2500	2500	2500
-taxes	=(Pretax cash flows)*(1-tax)		-4125	1875	1875	1875	1875	1875
+Depreciation			8000	0	0	0	0	0
=after tax operating cash flow			3875	1875	1875	1875	1875	1875
reversal of working capital								-1700
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)							600
+Tax shield on salvage book value	=Salvage value * tax rate							0
=Terminal year after tax cash flows								-1100
Total Cash flow for the period		-3825	3875	1875	1875	1875	1875	775
Discount factor=	(1+discount rate)^corresponding period	1	1.11	1.2321	1.367631	1.5180704	1.6850582	1.8704146
Discounted CF=	Cashflow/discount factor	-3825	3490.990991	1521.792062	1370.98384	1235.1206	1112.7212	414.34665
NPV=	Sum of discounted CF=	5320.96

Replace old machine as incremental NPV is positive

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