Question

8. Replacement analysis

Green Moose Industries is a company that produces iGadgets, among several other products. Suppose that Green Moose Industries considers replacing its old machine used to make iGadgets with a more efficient one, which would cost $1,700 and require $380 annually in operating costs except depreciation. After-tax salvage value of the old machine is $700, while its annual operating costs except depreciation are $1,000. Assume that, regardless of the age of the equipment, Green Moose Industries’s sales revenues are fixed at $4,500 and depreciation on the old machine is $700. Assume also that the tax rate is 40% and the project’s risk-adjusted cost of capital, r, is the same as weighted average cost of capital (WACC) and equals 10%.

Based on the data, net cash flows (NCFs) before replacement are__________ , and they are constant over four years.

Although Green Moose Industries’s NCFs before replacement are the same over the 4-year period, its NCFs after replacement vary annually. The following table shows depreciation rates over four years.

	Year 1	Year 2	Year 3	Year 4
Depreciation rates	33.33%	44.45%	14.81%	7.41%

Complete the following table and calculate incremental cash flows in each year. Hint: Round your answers to the nearest dollar and remember to enter a minus sign if the calculated value is negative.

	Year 0	Year 1	Year 2	Year 3	Year 4
New machine cost	$1,700
After-tax salvage value, old machine	$700
Sales revenues		$4,500	$4,500	$4,500	$4,500
Operating costs except depreciation		$380	$380	$380	$380
Operating income		$	$	$	$
After-tax operating income		$	$	$	$
Net cash flows after replacement (adding back depreciation)		$	$	$	$
Incremental Cash Flows	$	$	$	$	$

Next evaluate the incremental cash flows by calculating the net present value (NPV), the internal rate of return (IRR), and the modified IRR (MIRR). Assume again that the cost of financing the new project is the same as the WACC and equals 10%. Hint: Use a spreadsheet program’s functions or use a financial calculator for this task.

	NPV	IRR	MIRR
Evaluation

Based on the evaluation, replacing the old equipment appears to be a________(good/bad) decision because____________(the MIRR is lower than the IRR/ the NPV is negative/ the IRR is small).

Answer 1

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