Question

The Wagner Company currently uses an injection-molding machine that was purchased 2 years ago. This machine is being depreciation on a straight-line basis, and it has 6 years of remaining life. Its current book value is $2,100, and it can be sold for $2,500 at this time. Thus, the annual depreciation expense is $2,100/6=$350 per year. If the old machine is not replaced, it can be sold for $500 at the end of its useful life. Wagner is offered a replacement machine that has a cost of $8,000, an estimated useful life of 6 years, and an estimated salvage value of $800. This machine falls into the MACRS 5-year class, so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The replacement machine would permit an output expansion, so sales would rise by $1,000 per year; even so, the new machine's much greater efficiency would reduce operating expenses by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500. Wagner's marginal federal-plus-state tax rate is 40%, and its WACC is 15%. Should it replace the old machine?

Don't show the excel method please. Needs to be written down

Answer 1

1]	The incremental free cash flows of the replacement are worked out in the table below:
		0	1	2	3	4	5	6
	Incremental sales		$       1,000	$       1,000	$       1,000	$          1,000	$         1,000	$         1,000
	+Reduction in operating expenses		$       1,500	$       1,500	$       1,500	$          1,500	$         1,500	$         1,500
	-Incremental depreciation:
	Depreciation on the new machine		$       1,600	$       2,560	$       1,520	$             960	$             880	$            480
	Depreciation on the old machine		$          350	$          350	$           350	$             350	$             350	$            350
	Incremental depreciation		$       1,250	$       2,210	$       1,170	$             610	$             530	$            130
	Incremental NOI		$       1,250	$          290	$       1,330	$          1,890	$         1,970	$         2,370
	-Tax at 40%		$          500	$          116	$           532	$             756	$             788	$            948
	=Incremental NOPAT		$       1,750	$          406	$       1,862	$          2,646	$         2,758	$         3,318
	+Incremental depreciation		$       1,250	$       2,210	$       1,170	$             610	$             530	$            130
	=Incremental OCF		$       3,000	$       2,616	$       3,032	$          3,256	$         3,288	$         3,448
	-Cost of the new machine	$         8,000
	+After tax salvage of the old machine = 2500-(2500-2100)*40% =	$         2,340
	-Change in NWC [2000-500]	$         1,500						$      (1,500)
	+Incremental after tax terminal salvage value = (800-500)*(1-40%) =							$            180
	FCF	$    (11,840)	$       3,000	$       2,616	$       3,032	$          3,256	$         3,288	$         5,128
2]	Calculation of NPV at the discount rate of 15%:
	PVIF at 15% [PVIF = 1/1.15^t]	1	0.86957	0.75614	0.65752	0.57175	0.49718	0.43233
	PV of FCF at 15%	$    (11,840)	$       2,609	$       1,978	$       1,994	$          1,862	$         1,635	$         2,217
	NPV [Sum of PV of FCF of years 0 to 6]	$            454
3]	As the NPV of the replacement is positive, the old machine should be replaced.