Question

Problem 11-14
Replacement Analysis

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 $700,000 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 $260,000. The old machine is being depreciated by $140,000 per year for each year of its remaining life.

The new machine has a purchase price of $1,175,000, 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 14%.

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

What is the NPV? Round answer to 4 decimal places.

Answer 1

a)

Formulas Used:

b) First we need to find the initial cash outlay at time 0

To find the net cash outlay at time 0 we need to first find the proceeds from the sale of the old equipment. For this we need to find its book value so as to calculate the tax applicable.

Depreciation per year of old equipment = $140,000

Current book value = $700,000

Current Selling Value = $260,000

Therefore, tax will be applicable on (Sale price - Book Value) = $260,000 - $700,000 = -$440,000

Proceeds from sale after taking tax effect into consideration = $260,000 - (0.35*-$440,000) = $414,000

Net cash outflow at time 0 = Purchase cost - Proceeds from sale = $1,175,000 - $414,000 = $761,000

NPV calculation:

NPV = $123,988.1792

Formulas used: