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 $450,000 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 $135,000. The old machine is being depreciated by $90,000 per year for each year of its remaining life. If DeYoung doesn't replace the old machine, it will have no salvage value at the end of its useful life.

The new machine has a purchase price of $775,000, 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 $205,000 will be realized if the new machine is installed. The company's marginal tax rate is 25% and the project cost of capital is 15%.

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. What is the incremental depreciation tax shield (i.e., the change taxes due to the change in depreciation expenses) if the replacement is made? (Hint: First calculate the annual depreciation expense for the new machine and compare it to the depreciation on the old machine.) Do not round intermediate calculations. Round your answers to the nearest dollar. Negative values, if any, should be indicated by a minus sign.

   Year	Incremental depreciation tax shield
   1	$
   2	$
   3	$
   4	$
   5	$

3. What is the after-tax salvage value at Year 5? Do not round intermediate calculations. Round your answer to the nearest dollar. Negative value, if any, should be indicated by a minus sign.

   $  

4. What are the total incremental project cash flows in Years 0 through 5? What is the NPV? Do not round intermediate calculations. Round your answers to the nearest dollar. Negative values, if any, should be indicated by a minus sign.

   CF0	$
   CF1	$
   CF2	$
   CF3	$
   CF4	$
   CF5	$
   NPV	$

Answer 1

a) As visible question is based on machinary replacement analysis: -

Initial Net Cashflows are calculated as follows: -

Sr. No.	Particulars	Amount(Rs. in $)	Remarks
1.	Purchase of New machinary	-7,75,000	Being cash to be paid for purchasing macinary
2.	Sales Proceeds	1,35,000	Being amount realised on sale of old machine
3.	Tax benefit on sale of old machine	78,750	Being Net loss on sale of machine ($4,50,000 - $1,35,000) will generate tax benefits calculated at marginal rate of tax i.e. 25%
4	Net Initial Cashflows	-5,61,250

b) Change in Depriciation Tax Shield is calculated as follows: -

Year	Depreciation	Change in Depreciation Tax Shield
Old Machinary	New Machinary
1	22,500	38,750	16,250
2	22,500	62,000	39,500
3	22,500	37,200	14,700
4	22,500	22,320	-180
5	22,500	22,320	-180
	1,12,500	1,82,590	70,090

Notes:-

1. It is mentioned in question old machine is depreciated on straight line basis and therefore tax sheild is calculated as follows:-

Depreciation x Tax Rate

=$90,000 x 25%

=$22,500

2. For new machinary, different depreciation rates are mentioned for each year therefore depreciation tax shield is calculated as follows: -

Purchase Value - $7,75,000

Year	Depreciation rate	Deprecaition	Tax Shield @25%
1	20%	1,55,000	38,750
2	32%	2,48,000	62,000
3	19.2%	1,48,800	37,200
4	11.52%	89,280	22,320
5	11.52%	89,280	22,320
		7,30,360	1,82,590

Assumptions: -

1. Since it is not clearly mentioned in question whether depreciation rates for new machinary are based on initial value or written down value. Therefore we have assumed depreciation ratesmentioned are at initial purchase price

2. Some misprint is assumed in question as depreciation rates mentioned are for 6 years but useful life is 5 years only therefore we have taken first five depreciation rates for calculation.

c) Calculation of terminal cashflows: -

1. Realisation of salvage value = $ 1,05,000

2. Tax payable on realised profits of $60,360 calculaed as difference of Sale Proceeds ($1,05,000) and Book Value $44,640 [$7,75,000 - $7,30,360(Depreciation calculated in b.)]

Tax rate = 25%

Tax Payable = 25% of 60,360

= -$15,090

3. Threfore net terminal cashflows will be (1 + 2) = $89,910

d) Calculation of annual cashflows and NPV: -

NPV is sum of initial, terminal and annual cashflows.

We have already calculated initial, terminal cashflows in above subparts.

Now let us calculate annual cashflows as follows: -

Year	Savings	Tax Payable in Savings	Net Savings	Depreciation tax shield	Net Cashflows	Discounted Cashflows
1	2,05,000	51,250	1,53,750	38,750	1,92,500	1,67,391.30
2	2,05,000	51,250	1,53,750	62,000	2,15,750	1,63,138.00
3	2,05,000	51,250	1,53,750	37,200	1,90,950	1,25,552.72
4	2,05,000	51,250	1,53,750	22,320	1,76,070	1,00,668.59
5	2,05,000	51,250	1,53,750	22,320	1,76,070	87,537.91
Sum of net annual cashflows	$6,44,288.52

Notes: -

1. It is mentioned in question annual savings will be$2,05,000;

2. Tax will be paid on annual savings and therefore reduced from savings for calculating net annual cashflows;

3. Tax shield on depreciation is already calculated in subpart b) . You may check b) for its calculation;

4. Tax shield on depreciation of new machinary will be added in cashflows at depreciation is non cash expense but will provide benefit of reduction in tax payable.

5. Annual cashflows are discounted at 15% as Cost of return mentioned in question

NPV is calculated as follows: -

Sum of initial, terminal and annual cashflows.

Initial = -$5,61,250

Annual = $6,44,288.52

Terminal =$89,910

NPV = $1,72,948

Since NPV is positive, proposal should be accepted i.e. machinary should be replaced now.