Question

QUESTION 7

Contreras, Inc. is analyzing the replacement of a color copier. The old machine was purchased 4 years ago for $40,000; it falls into the MACRS 7-year class; and it has 3 years of remaining life and a $7,000 salvage value 3 years from now. The current market value of the old machine is $14,000. The new machine has a price of $50,000, plus an additional $300 for installation and modification. Delivery of the machine will require $200. The new machine falls into the MACRS 7-year class, has a 3-year economic life, and can be salvaged for $18,000. The new machine will allow for a $3,000 increase in inventory, and accounts payable is expected to increase by $1,000. The new machine is expected to increase revenue by $15,000 per year and increase costs by $3,000 per year. The firm has a 13 percent cost of capital and a marginal tax rate of 21 percent. The MACRS 7-year class uses the following percentages: 14%, 25%, 17%, 13%, 9%, 9%, 9%, and 4% (in that order). (Round all CFs to the nearest dollar.)

What is the initial investment outlay at Year 0?

	A.	Outflow of $38,836
	B.	Outflow of $36,164
	C.	Outflow of $38,084
	D.	Outflow of $37,916
	E.	Outflow of $40,164

If they switch out the old machine for the new one, how much more tax savings will the company get from the change in depreciation expense in Year 2 (t = 2)?

1. 	A.	$1,895
   	B.	$11,375
   	C.	$2,632
   	D.	$9,025
   	E.	$7,426

What is the tax effect from selling the new machine at the end of the project

	A.	Inflow of $886
	B.	Inflow of $462
	C.	None of the other choices is correct.
	D.	Outflow of $462
	E.	Outflow of $886

Should the firm replace its older machine with the new machine?

	A.	None of the other choices is within $100 of the correct answer.
	B.	No, buying the new machine would lower the firm’s value by $3,188 expressed in today's dollars.
	C.	No, buying the new machine would lower the firm’s value by $4,416 expressed in today's dollars
	D.	No, buying the new machine would lower the firm’s value by $5,297 expressed in today's dollars.
	E.	No, buying the new machine would lower the firm’s value by $6,871 expressed in today's dollars.

Answer 1

1. Book Value of OLD machine now

Year	Rate	Depreciation
1	14	5600
2	25	10000
3	17	6800
4	13	5200
	Total	27600

Book Value = 40000-27600 = 12400

Proceeds from sale of OLD machine

Sale Value	14000
Less Book Value	12400
Capital Gain	1600
Tax @ 21%	336
Net Proceeds From sale	13664

Caluclation of Initial Investment

A. Initial Investment (Year 0)
Cost of New Machine	50,000
Installation	300
Delivery	200
Increase in Working Capital (3000-1000)	2,000
Less : Proceeds from sale	-13,664
Total Outlow	38,836

Option A

2. Tax Saving in Year 2 Due to depreciation

Year	OLD Machine	New Machine	Additional Depreciation	Tax Saving @ 21%
1	3600	7070	3470	728.7
2	3600	12625	9025	1895.25

Tax Saving = 1895.25 OPTION A

3

Year	Rate	Depreciation
1	14	7070
2	25	12625
3	17	8585
	Total	28280
Book Value	22220

Sale Value	18000
Less Book Value	22220
Capital Gain	-4220
Tax inflow @ 21%	-886.2

Tax Inflow = -886.2 OPTION A

4. Calculation of NPV

Calculation of PV of annual Cash Flow

Year	OLD Machine	New Machine	Additional Depreciation
1	3600	7070	3470
2	3600	12625	9025
3	3600	8585	4985

Particulars	1	2	3
Increase in Operating Profit (15000-3000)	12,000.00	12,000.00	12,000.00
Less : incremental Depreciation	3,470.00	9,025.00	4,985.00
Earning Before Tax	8,530.00	2,975.00	7,015.00
Less : Tax @ 21%	1,791.30	624.75	1,473.15
Earning After Tax	6,738.70	2,350.25	5,541.85
Add Back : Depreciation	3,470.00	9,025.00	4,985.00
Cash flow After Tax	10,208.70	11,375.25	10,526.85
PV @ 13%	11,535.83	8,908.49	7,295.64

Total PV of Cash flow = 27740

Calculaton of PV of Terminal Value

Particulars	New	Old	Incremental
Sale Value	18000	7000	11000
Less Book Value	22220	1600	20620
Capital Gain	-4220	5400	-9620
Tax @ 21%	-886.2	1134	-2020.2
Net Proceeds From sale	18886.2	5866	13020.2
WC recovery			2000
Terminal Value at Year 3			15020.2
PV @ 13%			9,023.65

Calculation Of NPV
Initial Outflow (A)	-38,836.00
PV of Annual Cash Flow (B)	27,740.00
PV of Terminal Cash Flow "C"	10,409.00
Net Present Value	-687

OPTION A