Question

Replacement Analysis

The Everly Equipment Company's flange-lipping machine was purchased 5 years ago for $55,000. It had an expected life of 10 years when it was bought and its remaining depreciation is $5,500 per year for each year of its remaining life. As older flange-lippers are robust and useful machines, this one can be sold for $20,000 at the end of its useful life.

A new high-efficiency digital-controlled flange-lipper can be purchased for $150,000, including installation costs. During its 5-year life, it will reduce cash operating expenses by $30,000 per year, although it will not affect sales. At the end of its useful life, the high-efficiency machine is estimated to be worthless. MACRS depreciation will be used, and the machine will be depreciated over its 3-year class life rather than its 5-year economic life, so the applicable depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%.

The old machine can be sold today for $40,000. The firm's tax rate is 35%, and the appropriate cost of capital is 16%.

1. If the new flange-lipper is purchased, what is the amount of the initial cash flow at Year 0? Round your answer to the nearest dollar. Cash outflow, if any, should be indicated by a minus sign.

   $  

2. What are the incremental net cash flows that will occur at the end of Years 1 through 5? Do not round intermediate calculations. Round your answers to the nearest dollar. Cash outflows, if any, should be indicated by a minus sign.

   CF1	$
   CF2	$
   CF3	$
   CF4	$
   CF5	$

3. What is the NPV of this project? Do not round intermediate calculations. Round your answer to the nearest whole dollar. Negative value, if any, should be indicated by a minus sign.

   $  

   Should Everly replace the flange-lipper?

   -Select-YesNo

Answer 1

a) We have in this question three important information in order to determine the initial cash flow at Year 0, they are

1) Flange lipping machine was purchased 5 years ago with a cost of $55,000 and had an expected life of 10 years.

2) The new digital machine purchased at $ 150,000 including installation cost.

3) The old machine, that is, which was purchased 5 years ago can be sold at $40,000 and there is a tax rate of 35%.

Based on the above information, we can determine the Cash flow at year 0 , which is net cash outflow.

Step 1: Using Information 1), we will depreciate the assets based on its useful life for 5 years in order to reach its book value at the end of Year 5, which is now, i.e Year 0 for decision making for new machine purchase.

Book Value of old Machine = Original cost - depreciation over its useful life of 10 years at 5th year

As MACRS depreciation is to be used,

Depreciation for 5 years = ($55,000/10)*5 = $27,500

Book Value of Machine at 5th year = Purchased Price – Depreciation Value

= $55,000- $27,500

= $27,500

Step 2: Using Information 3, it can be sold for $40,000

Therefore net gain or cash inflow would be = Sold Price - Book Value of Machine at 5th year

= $40,000 - $27,500

= $12,500

Using tax rate of 35%,

Tax expense = Net cash inflow * Tax rate

= $12,500 * 35%

= $4,375 (which is cash outflow)

Step 3: Net Cash inflow from sale of old Assets = Cash inflow from sale of old assets from Step 2 - Tax expenses (from Step 2)

= $12,500 - $4,375

= $8,125

Step 4: Using information 2 , Cash outflow for new machine is $150,000.

Therefore net cash flows are:

Particulars	Amount( $)
Cash outflow for new machine	150,000
Less: Net Cash inflow from old assets ( as per Step 3)	8,125
Net Cash outflow at Year 0	141,875

b) Net Incremental Cash flows = Present Value of Reduced Cash Operating Expenses + Present value of Saving on Depreciation.

Let us Calculate the Present Value of reduced Cash Operating Expenses

Discounting Factor after tax = Cost of Capital (1- Tax Rate)

= 16%(1 - 0.35)

= 10.4%

Year	Reduced Cash operating Expenses ($)	Discounting Factor @ 10.4%	Discounted Value ($)
1	30,000	0.90579710145	33,120.00
2	30,000	0.82046838899	36,564.48
3	30,000	0.74317788858	40,367.19
4	30,000	0.67316837734	44,565.37
5	30,000	0.60975396498	49,200.17
		Total	203,817.21

Now we will calculate Depreciation and its Present Value.

Since MACRS Depreciation is used thereby reducing the years from 5 to 3 year class life.

Depreciation Chart and Present Value on Tax Saving on Depreciation
Years	Rate of Depreciation (1)	Depreciation ($) (2)= (1) *$150,000	Tax Saving ($)(3) = (2)*.35	Discounted factor @ 10.4% (4)	Present Value of Depreciation ($) (5) = (3)*(4)
1	33.33%	49,995	17,498.25	0.90579710145	15,849.86
2	44.45%	66,675	23,336.25	0.82046838899	19,146.66
3	14.81%	22,215	7,775.25	0.74317788858	57,78.39
4	7.41%	11,115	3,890.25	0.67316837734	26,18.79

Now, net incremental cash flow chart is as follows:

Years	Present Value of reduced Cash Operating Expenses ($) (1)	Present Value on Tax Saving on Depreciation ($) (2)	Net Incremental Cash flows ($) (3)= (1)+(2)	Rounded of Net Incremental Cash Flows ($)
1	33,120.00	15,849.86	48969.86	48,970
2	36,564.48	19,146.66	55711.14	55,711
3	40,367.19	57,78.39	46145.58	46,146
4	44,565.37	26,18.79	47184.16	47,184
5	49,200.17	-	49,200.17	49,200
	Net Incremental Cash flows	247,211

c) NPV of the project = Net Incremental Cash flows (in $) - Cash outflows at Year 0 (in $)

                                    = $247,211 - $141,875

                                    = $105,336

Yes, Everly should replace the machine as the net present value is positive of $105,336.