Question

. Replacement decision

The electronics company plans to replace the manually operated manufacturing machine with a new fully automated machine. Use the following information to determine the cash flows and profitability of the replacement decision.

Current situation

• Current estimated wages of operators are 30,000 annually. By replacing, we can save these labour related costs.

• Maintenance costs € 8,000 per year.

• Waste related costs of € 10,000 per year

• The machine currently in use was bought 5 years ago for 60,000 euros. The company can continue to operate this machine for the next five years. The company applies linear depreciation and both the book and market values are zero after five years.

• The potential sales price of the old machine today is € 20,000

Project under consideration

• Required capital investment is € 120,000
• Maintenance costs € 14,000 per year.
• Waste related costs of € 5,000 per year
• The machine is going to be operated for the next 5 years
• Linear depreciation is applied. Accounting salvage value is zero after 5 years of operation. However, it is estimated that the potential market value of the new machine is 25% of the purchase price.
• Replacement requires additional investments of € 12,000 into net working capital, which is expected to be recovered when project ends.
• The company applies 10% cost of capital for this type of replacement projects
• Corporate tax rate is 40% on both profits and capital gains.

Find:

a) Incremental cash flows from replacing the machine (including investment, annual cash flow, and closing cash flow)

d) Based on the NPV, assess whether the replacement is economically viable

Answer 1

Replacement analysis
Year	0	1	2	3	4	5
1.Initial investment	-120000
1.a.After-tax sale value of old m/c(as per wkgs.)	24000
2.Incl.NWC reqd.& recovered	-12000					12000
3.After-tax salvage of new m/c(120000*25%*(1-40%))						18000
4.After-tax savings in Wages of operators(30000*(1-40%))		18000	18000	18000	18000	18000
5.After-tax Incl.maintenance costs(14000-8000)*(1-40%)		-3600	-3600	-3600	-3600	-3600
6.After-tax savings in waste-related costs(10000-5000)*(1-40%)		3000	3000	3000	3000	3000
7.Incl.depn. Tax shield((120000/5)-(60000/10))*40%		7200	7200	7200	7200	7200
8.Total incl.cash flows(sum1+1a+.. to 7)         (ANSWER   a.)	-108000	24600	24600	24600	24600	54600
9.PV F at 10%(1/1.10^Yr.n)	1	0.90909	0.82645	0.75131	0.68301	0.62092
10.PV at 10%(8*9)	-108000	22363.64	20330.58	18482.34	16802.13	33902.3
11. NPV(Sum of Row 10)	3880.99
b. Replacement is economically viable & RECOMMENDED
as the NPV (at the company's COC 10%) , of the decision to replace is POSITIVE.

Workings:
After-tax salvage of Old m/c
Cost	60000
Less:Acc. Depn.(60000/10=6000*5 yrs.)	30000
Carrying value	30000
current sale value	20000
Loss on sale(30000-20000)	10000
Tax cash outflow saved on loss(10000*40%)	4000
After-tax salvage(20000+4000)	24000