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 $500,000 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 $150,000. The old machine is being depreciated by $100,000 per year for each year of its remaining life.

The new machine has a purchase price of $875,000, 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, annual pre-tax savings of $195,000 will be realized if the new machine is installed. The company's marginal tax rate is 35% and the project cost of capital is 14%.

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. Cash outflow, if any, should be indicated by a minus sign.

   $  

2. 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. Negative values, if any, should be indicated by a minus sign.

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

3. What are the incremental net cash flows in 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	$

4. Should the firm purchase the new machine? Support your answer. Do not round intermediate calculations. Round your answer to the nearest dollar. Negative value, if any, should be indicated by a minus sign.

   NPV: $  

   The firm -Select-shouldshould notItem 23 purchase the new machine.

5. In general, how would each of the following factors affect the investment decision, and how should each be treated?

   1. The expected life of the existing machine decreases.

      If the expected life of the old machine decreases, the new machine will look -Select-betterworseItem 24 as cash flows attributable to the new machine would -Select-decreaseincreaseItem 25 .

   2. The cost of capital is not constant but is increasing as DeYoung adds more projects into its capital budget for the year.

      The -Select-higherlowerItem 26 capital cost should be used in the analysis.

Answer 1

cost of new machine		-875000
tax benefits on sale of old machine	(500000-150000)*35%	122500
sale proceeds of old machine		150000
net cost of replacement		-602500
Year	Depreciation allowance new machine = cost of new machine* MACRS dep rate	Depreciation allowance old machine	Incremental depreciation
1	175000	100000	75000
2	280000	100000	180000
3	168000	100000	68000
4	100800	100000	800
5	100800	100000	800
Incremental cash flow
Year	pretax savings	less incremental depreciation	operating savings	after tax saving = operating saving*(1-tax rate)	net operating cash savings = after tax savings+ depreciation
1	195000	75000	120000	78000	153000
2	195000	180000	15000	9750	189750
3	195000	68000	127000	82550	150550
4	195000	800	194200	126230	127030
5	195000	800	194200	126230	212920
cash flow in year 5
scrap value of machine		105000
less book value of machine		50400
gain on sale of machine		54600
less tax on gain on scrap value	54600*35%	19110
net proceeds from scrap	105000-19110	85890
cash flow in year 5	after tax savings+depreciation +net proceeds from scarp value
Year	cash flow	present value of cash flow = cash flow/(1+r)^n r = 14%
0	-602500	-602500
1	153000	134210.5263
2	189750	146006.4635
3	150550	101616.9618
4	127030	75211.95763
5	212920	110583.976
Net present value =sum of present value of cash flow		-34870.11474
No machine should not be purchased as NPV at 14% is negative
1-	better	Increase
2-	Higher