Question

REPLACEMENT ANALYSIS

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 $550,000 and a remaining useful life of 5 years. The firm does not expect to realize any return from scrapping the old machine in 5 years, but it can sell it now to another firm in the industry for $235,000. The old machine is being depreciated by $110,000 per year, using the straight-line method.

The new machine has a purchase price of $1,100,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $155,000. The applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected to economize on electric power usage, labor, and repair costs, as well as to reduce the number of defective bottles. In total, an annual savings of $205,000 will be realized if the new machine is installed. The company's marginal tax rate is 35%, and it has a 12% WACC.

1. What initial cash outlay is required for the new machine? Round your answer to the nearest dollar. Negative amount should be indicated by a minus sign.
   $
   

2. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made. Round your answers to the nearest dollar.

   Year	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation
   1	$	$	$
   2
   3
   4
   5

3. What are the incremental net cash flows in Years 1 through 5? Round your answers to the nearest dollar.

   Year 1	Year 2	Year 3	Year 4	Year 5
   $	$	$	$	$

4. Should the firm purchase the new machine?
   -Select-YesNoItem 22

Answer 1

Step 1:
Calculation of After tax sale of value of Old machine
Sale Value of Old Machine = $235,000
Book Value of Old Machine = $550,000
Loss on sale                                = -$315,0000
Tax Credit on loss @35%      = $110,250
After tax sale Value                 = $345,250
Step 2:
Net Cashflow if new machine is purchased and old machine is replaced
Purchase of New machine = ($1,100,000)
Less: Sale of Old Machine = $345,250
Net Initial Cash Outflow    = ($754,750)
Step 2:
Computation of Incremental Annual Depreciation Expense
Year	Depreciation Rates	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation
A	B	C = $1,100,000 * B	D	E = C-D
1	20%	220000	110000	110000
2	32%	352000	110000	242000
3	19.20%	211200	110000	101200
4	11.52%	126720	110000	16720
5	11.52%	126720	110000	16720

Part (c ):
Calculation of Incremental Net Cashflows
Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Annual Pre tax Savings (A)	205000	205000	205000	205000	205000
Less: incremental Depreciation (B)	110000	242000	101200	16720	16720
Profit Before Tax (C = A-B)	95000	-37000	103800	188280	188280
Less: Tax @35% (D = C*35%)	33250	-12950	36330	65898	65898
Profit After Tax (E = C-D)	61750	-24050	67470	122382	122382
Addback Depreciation (F = B)	110000	242000	101200	16720	16720
Net Operating Cashflows (G = E+F)	171750	217950	168670	139102	139102
Additional Cashflow in Year 5
Salvage value (H)					155000
Less: Depreciation (I) ($1,100,000 *5.76%)					63360
Profit on sale(J = H-I)					91640
Less: Tax @35% (K = J*35%)					32074
Profit After Tax (L = J-K)					59566
Addback Depreciation (M = I)					63360
Net Salvage Value after tax (N = L+M)					122926
Total Cashflows (O = G+N)	171750	217950	168670	139102	262028

Part (d):
Calculation of NPV of the Project
Year	Cash flows	Discount Rate @12%	Discounted Cash flows
A	B	C = 1/(1+12%)^A	D = B*C
0	-754750	1	-754750
1	171750	0.892857143	153348.2143
2	217950	0.797193878	173748.4056
3	168670	0.711780248	120055.9744
4	139102	0.635518078	88401.83574
5	262028	0.567426856	148681.7242
Net Present Value of Maceine	-70513.84581
NPV of the Project is -$70,513.85
Firm should not purchase the new machine