Question

Project 2: Micah’s Replacement Decision

Project description

MicahCorporation is trying to determine the initial investment required to replace an old machine with a new one. The new machine costs $380,000, and an additional $20,000 will be necessary to install it. It will be depreciated under MACRS, using a 5-year recovery period. The 5-year MACRS depreciation rates are:

Year	1	2	3	4	5	6
Depreciation	20%	32%	19%	12%	12%	5%

The old machine was purchased 3 years ago at a cost of $240,000 and was being depreciated under MACRS, using a 5-year recovery period. The firm can sell the old machine for $280,000. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement. The firm’s tax rate is 21%.

The new machine and the old machine are associated with the following EBITDA (earnings before interest, taxes, depreciation and amortization) over the 5-year life of the project:

Year	1	2	3	4	5
New machine’s EBITDA	220,000	220,000	220,000	220,000	220,000
Old machine’s EBITDA	210,000	190,000	170,000	150,000	130,000

Assume that the firm expects to liquidate the new machine at the end of its 5-year usable life, to net $50,000 after paying removal and cleanup costs. Had the new machine not replaced the old machine, the old machine would have been liquidated after 5 years to net $10,000. The firm expects to recover its net working capital investment upon termination of the project.

If the corporation’s capital structure is 50% debt and 50% equity, and the corporation will continue this capital structure to fund the investment on the new machine. Its cost of debt is 5% and cost of equity is 12%. Should Micah do the replacement? Support your conclusion with NPV and IRR values.

Requirements

1. Present the case solution in an Excel file with clear labels, functions and descriptions.

2. Starting with the data provided, show each step of your work that leads to the conclusion.

3. Due in D2L by 11:59PM Sunday June 1.

Hints

1. You may need the following equations:

FCF=EBIT×(1-T)+DP-net CAPX-ΔNWC

WACC=wd×rd×(1-T)+w_s×r_s

After-tax salvage value=MV-(MV-BV) ×T

Excel function of NPV, Excel function of IRR

2. It is a replacement decision and you need to consider the effect of the new machine relative to that of the old one.

Grading

7 points in total

Finished and submitted on time: 3 points

0-25% correct: +1

25%-50% correct: +2

50%-75% correct: +3

75%-100% correct: +4

***Please show all excel functions in answer***

Answer 1

Solution:

Following steps are followed:

a. Compute the free cash flows considering only old machine

b. Consider the cash flows considering New machine + Old Machine Sold

c. Compute the difference between the two cash flows

d. Compute WACC

e. Compute NPV and IRR

Excel computations are attached.

Some points to be noted.

Cash flows from selling of the machine = Selling Price of the Machine - (SP of machine - Net Block)* tax rate.... this is done since Net Gains from sale of machine will be taxed.

Considering the NPV and IRR, Micah should do the replacement.

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