Question

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 $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 $265,000. 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 $1,160,000, 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%.

1. 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.
   $
2. 
   
3. 
   
4. 
   
5. Calculate the annual depreciation allowances for both machines, and compute the change in the annual depreciation expense if the replacement is made. Do not round intermediate calculations. Round your answers to the nearest dollar.

   Year	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation
   1	$	$	$
   2	$	$	$
   3	$	$	$
   4	$	$	$
   5	$	$	$

6. 
   
7. What are the incremental net cash flows in Years 1 through 5? Do not round intermediate calculations. Round your answers to the nearest dollar.

   CF1	$
   CF2	$
   CF3	$
   CF4	$
   CF5	$

8. 
   
9. Should the firm purchase the new machine?
   -Select-YesNoItem 22
   
   Support your answer. Do not round intermediate calculations. Round your answer to the nearest dollar.
   
   NPV: $

Answer 1

Old Machine			New Machine
Book Value	$800,000		Purchase Value	$1,160,000
Life	5		Life	5
Deperciation p.a	$160,000
Salvage Value	$265,000		Salvage Value	$105,000
			Depreciation Year wise (Purchase Value * Rate)
				1	$232,000	20.00%
				2	$371,200	32.00%
				3	$222,720	19.20%
				4	$133,632	11.52%
				5	$133,632	11.52%
				6	$66,816	5.76%
				Total	$1,160,000	100%
a. Initial Cash Flow
Initial cash flow to purchase new machine and to replace old once will be
Purchase value of New Machine - Salvage Value of old machine
$1160000 - $265000 = $ 895000
b. Incremental Depreciation
Year	Deperciation (old)	Depreciation (New)	Differential Deperciation
	$800000/5	(at given rates)
1	$160,000	$232,000	-$72,000
2	$160,000	$371,200	-$211,200
3	$160,000	$222,720	-$62,720
4	$160,000	$133,632	$26,368
5	$160,000	$133,632	$26,368
c . Incremental Cash Flow
As depreciation is a non-cash expenditure, incremental cash flow would only consist of annual savings net of tax
Year	Annual Saving	Tax @ 35%	Incremental Cash Flow (Annual saving - tax)
1	$ 255,000.00	$     89,250.00	$            165,750.00
2	$ 255,000.00	$     89,250.00	$            165,750.00
3	$ 255,000.00	$     89,250.00	$            165,750.00
4	$ 255,000.00	$     89,250.00	$            165,750.00
5	$ 255,000.00	$     89,250.00	$            165,750.00
d. Net Present Value (NPV)
Year	Type of Cash Inflow	Cash Flow	Discount Factor @ 13%	Discounted Cash Flow (Cash flow * Discount Factor
1	Annual Saving	$   165,750.00	0.8850	$                   146,681.42
2	Annual Saving	$   165,750.00	0.7831	$                   129,806.56
3	Annual Saving	$   165,750.00	0.6931	$                   114,873.06
4	Annual Saving	$   165,750.00	0.6133	$                   101,657.58
5	Annual Saving	$   165,750.00	0.5428	$                     89,962.46
5	Salvage value (new Machine	$105,000	0.5428	$                     56,989.79
	Incremental Cash Inflow if Machine is replaced	$                   639,970.87
Less:	Initial Cash Outflow for purchase of Machine (a)	$                   895,000.00
	Net Present Value		$                 (255,029.13)
e. No, the new Machine should not be purchased as the NPV is negative
Though there is benefit in terms of saving, however in present value terms the initial outlay
overweights the benefits of the new machine