Question

Integrativelong dash—Investment decision

Holliday Manufacturing is considering the replacement of an existing machine. The new machine costs $1.18 million and requires installation costs of $159,000.The existing machine can be sold currently for $186,000 before taxes. It is 2 years​ old, cost $803,000 ​new, and has a $385,440 book value and a remaining useful life of 5 years. It was being depreciated under MACRS using a​ 5-year recovery period and therefore has the final 4 years of depreciation remaining. If it is held for 5 more​ years, the​ machine's market value at the end of year 5 will be $0 Over its​ 5-year life, the new machine should reduce operating costs by $359,000 per year. The new machine will be depreciated under MACRS using a​ 5-year recovery period. The new machine can be sold for $210,000 net of removal and cleanup costs at the end of 5 years. An increased investment in net working capital of $22,000 will be needed to support operations if the new machine is acquired. Assume that the firm has adequate operating income against which to deduct any loss experienced on the sale of the existing machine. The firm has a

9.3% cost of capital and is subject to a 40% tax rate.

a. Develop the net cash flows needed to analyze the proposed replacement.

b. Determine the net present value​ (NPV) of the proposal.

c. Determine the internal rate of return​ (IRR) of the proposal.

d. Make a recommendation to accept or reject the replacement​ proposal, and justify your answer.

e. What is the highest cost of capital that the firm could have and still accept the​ proposal?

Answer 1

Answer (a):

Old machine:

Purchase cost 2 years ago = $803,000

Depreciation schedule of old machine will be as follows:

Book value = $385,440

Sale value = $186,000

Tax benefit on loss = (385440 - 186000) * 40% = $79776

Sale value with tax benefit = 186000 + 79776 = $265,776

Yearwise Net Cash flows are calculated and given below:

Above excel with 'show formula' is given in answer below.

Answer (b) and (c):

NPV = $125,096.41

IRR = 13.37%

Working:

Above excel with 'show formula' is given below:

Answer (d):

The NPV of replacemet proposal is positive.

The IRR of replacement proposal is higher than cost of capital.

Hence it is recommended that the replacement proposal should be accepted.

Answer (e):

From answer c above we observe that the IRR of replacement proposal is 13.371%

The highest cost of capital that the firm could have and still accept the​ proposal is 13.37%