Question

J. Mourinho Transportation Company (JMTC) is considering the purchase of a new machine to replace the existing one to increase the productivity of the company in order to save the company from possible bankruptcy. The existing machine has a book value of $3,000 and can be sold for $4,000 in the market. The old machine is being depreciated on a straight-line basis, and its estimated salvage value 3 years from now is zero. The new machine will reduce costs (before taxes) by $7,000 per year. The new machine has a 3-year life, its price is $12,000 with an additional installation cost of $2,000, and it can be sold for an expected $2,500 at the end of the third year. The new machine would be depreciated over its 3-year life using the MACRS method. The new machine will require an increase in net operating working capital of $3,750. SOC’s marginal tax rate is 40 percent. Because this project is expected to be riskier than average projects, the company uses a risk-adjusted weight average cost of capital of 13.75 percent to evaluate the project. Please advise SOC to take or to reject this replacement project. You must show all your work clearly and step by step. Finally, please explain your approach in 5 lines in writing.

Answer 1

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