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 $600,000 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 $280,000. The old machine is being depreciated by $120,000 per year, using the straight-line method.

The new machine has a purchase price of $1,150,000, 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 $250,000 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

Answer 1

Part a:
Net Cashflow if new machine is purchased and old machine is replaced
Tax credit on sale of old machine = (Book value - sale value) * tax rate = ($600,000 - $280,000)*35% = $112,000
After tax sale value of Old Machine = Sale Value + Tax credit = $260,000 + $112,000 = $372,000
Purchase of New machine = $1,150,000
Less: After tax Sale Value = ($372,000)
Net Initial Cash Outflow    = $778,000
Part b:
Computation of Incremental Annual Depreciation Expense
Year	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation
1	230000	120000	110000
2	368000	120000	248000
3	220800	120000	100800
4	132480	120000	12480
5	132480	120000	12480

Part (c ):
Calculation of Incremental Net Cashflows
Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Operating Cash Flows
Annual Pre tax Savings (A)	250000	250000	250000	250000	250000
Less: incremental Depreciation (B)	110000	248000	100800	12480	12480
Profit Before Tax (C = A-B)	140000	2000	149200	237520	237520
Less: Tax @35% (D = C*35%)	49000	700	52220	83132	83132
Profit After Tax (E = C-D)	91000	1300	96980	154388	154388
Addback Depreciation (F = B)	110000	248000	100800	12480	12480
Net Operating Cashflows (G = E+F)	201000	249300	197780	166868	166868
Additional Cashflows in Year 5
Salvage value (H)					155000
Less: Depreciation (I) ($1,150,000 *5.76%)					66240
Net Salvage Value (J = H-I)					88760
Less: Tax @35% (K = J*35%)					31066
Profit After Tax (L = J-K)					57694
Addback Depreciation (M = I)					66240
Net Salvage Value after tax (N = L+M)					123934
Total Cashflows (O = G+N)	201000	249300	197780	166868	290802

Part (d):
Calculation of NPV of the Project
Year	Cashflows	Discount Rate @12%	Discounted Cashflows
A	B	C = 1/(1+12%)^A	D = B*C
0	-778000	1	-778000
1	201000	0.892857143	179464.2857
2	249300	0.797193878	198740.4337
3	197780	0.711780248	140775.8974
4	166868	0.635518078	106047.6307
5	290802	0.567426856	165008.8645
Net Present Value of Machine			12037.112
NPV = $12,037.11
The firm should purchase the machine since NPV > 0