Question

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DeYoung Entertainment Enterprises is considering replacing the latex molding machine it uses to fabricate rubber chickens with a newer, more efficient model. The old machine has a book value of $600,000 and a remaining useful life of 5 years. The current machine would be worn out and worthless in 5 years, but DeYoung can sell it now to a Halloween mask manufacturer for $265,000. The old machine is being depreciated by $120,000 per year for each year of its remaining life. The new machine has a purchase price of $1,180,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $105,000. The applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. Being highly efficient, it is expected to economize on electric power usage, labor, and repair costs, and, most importantly, to reduce the number of defective chickens. 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 the project cost of capital is 15%.

What is the initial net cash flow if the new machine is purchased and the old one is replaced? Round your answer to the nearest dollar. $

Calculate the annual depreciation allowances for both machines, and compute the change in the annual depreciation expense if the replacement is made. Do not round intermediate calculations. Round your answers to the nearest dollar.

Year Depreciation Allowance,New Depreciation Allowance, Old Change in Depreciation

1 $ $ $

2 $ $ $

3 $ $ $

4 $ $ $

5 $ $ $

What are the incremental net cash flows in Years 1 through 5? Do not round intermediate calculations. Round your answers to the nearest dollar.

CF1 $

CF2 $

CF3 $

CF4 $

CF5 $

Should the firm purchase the new machine? Support your answer. Do not round intermediate calculations. Round your answer to the nearest dollar.

Answer 1

1. Initial Net Cash Flow: - $ 797,750

Book value of the old machine : $ 600,000

Current salvage value : $ 265,000.

Loss on salvage = Salvage Proceeds - Book Value = $ ( 265,000 - 600,000) = $ (335,000)

Tax effect of loss on salvage = $ ( 335,000) x 0.35 = $ (117,250)

Salvage value of old machine after tax = $ 265,000 - $ ( 117,250) = $ 382,250

Initial net cash flow = Purchase price of new machine - After tax salvage of old machine = $ (1,180,000 ) + $ 382,250 = $ (797,750)

2. Incremental Depreciation :

Year	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation
1	$ 236,000	$ 120,000	$ 116,000
2	377,600	120,000	257,600
3	226,560	120,000	106,560
4	135,936	120,000	15,936
5	135,936	120,000	15,936
6	67,968	0	67,968
	$ 1,180,000	$ 600,000	$ 580,000

3. Incremental net cash flows:

Year	Incremental EBITDA	After Tax Salvage Value, New	Incremental Depreciation	Operating Cash Flows After Taxes
1	$ 250,000		$ 116,000	$ 203,100
2	250,000		257,600	252,660
3	250,000		106,560	199,796
4	250,000		15,936	168,078
5	250,000	$ 92,038.80	15,936	260,116

Operating Cash Flows after Taxes = Incremental EBITDA x ( 1 - t ) + Incremental Depreciation x t.

Book value of new machine at the end of 5 years = $ 67,968.

Gain on salvage = $ 105,000 - $ 67,968 = $ 37,032.

Tax effect of gain = $ 37,032 x 0.35 = $ 12,961.20

Salvage value after tax = $ 105,000 - $ 12,961.20 = $ 92,038.80

4. Computation of NPV at 15% required rate of return: $ ( 73,300)

Year	Net Cash Flows	PV factor at 15%	Present Values
0	$ ( 797,750)	1.00000	$ ( 797,750)
1	203,100	0.86957	176,609.67
2	252,660	0.75614	191,046.33
3	199,796	0.65752	131,369.87
4	168,078	0.57175	96,098.60
5	260,116	0.49718	129,324.47
		NPV	$ ( 73,301.06)

5. The firm should not purchase the new machine, as the investment has a negative NPV of $ 73,300.