Question

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 $800,000 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 $270,000. The old machine is being depreciated by $160,000 per year for each year of its remaining life.

The new machine has a purchase price of $1,185,000, 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 $255,000 will be realized if the new machine is installed. The company's marginal tax rate is 35% and the project cost of capital is 13%.

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.

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

Support your answer. Do not round intermediate calculations. Round your answer to the nearest dollar.

Answer 1

Initial net cash flow = Purchase price of new machine - Sale price of old machine - Tax savings loss on sale of old machine = $1,185,000 - $270,000 - [ ($800,000 - $270,000) x 35% ] = $729,500

Incremental Depreciation

Year	Depreciation of New machine (a)	Depreciation of old machine (b)	Incremental Depreciation
1	$1,185,000 x 20% = $237,000	$160,000	$77,000
2	$1,185,000 x 32% = $379,200	$160,000	$219,200
3	$1,185,000 x 19.20% = $227,520	$160,000	$67,520
4	$1,185,000 x 11.52% = $136,512	$160,000	(-)$23,488
5	$1,185,000 x 11.52% = $136,512	$160,000	(-)$23,488

Incremental net cash flows

Year	1	2	3	4	5
Annual Savings	$255,000	$255,000	$255,000	$255,000	$255,000
Less: Incremental Depreciation	$77,000	$219,200	$67,520	(-)$23,488	(-)$23,488
Incremental earnings before tax	$178,000	$35,800	$187,480	$278,488	$278,488
Less: Tax @35%	$62,300	$12,530	$65,618	$97,471	$97,471
Incremental net income	$115,700	$23,270	$121,862	$181,017	$181,017
Add: Incremental depreciation	$77,000	$219,200	$67,520	(-)$23,488	(-)$23,488
Incremental net cash flows	$192,700	$242,470	$189,382	$157,529	$157,529