Question

The Wagner Company currently uses an injection-molding machine that was purchased 2 years ago. This machine is being depreciated on a straight-line basis, and it has 6-years of remaining life. Its current book value is $2,100, and it can be sold for $2,500 at this time. Thus, the annual depreciation expense is $350 [($2,100/6) = $350 per year]. If the old machine is not replaced, it can be sold for $500 at the end of its useful life.

Wagner is offered a replacement machine that has a cost of $8,000, an estimated useful life of 6 years, and an estimated salvage value of $800. This machine falls into the MACRS 5-year class, so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The replacement machine would permit an output expansion, so sales would rise by $2,000 per year. Even so, the new machine’s much greater efficiency would reduce operating expenses by $3,000 per year. The new machine would require that inventories be increased by $4,000, but accounts payable would simultaneously increase by $1,000. Wagner’s marginal federal-plus-state tax rate is 40%, and its WACC is 15%.

Should The Wagner Company replace the old machine? Justify your answer.

Answer 1

	0	1	2	3	4	5	6
Incremental sales		$         2,000	$          2,000	$        2,000	$            2,000	$          2,000	$       2,000
Savings in operating cost		$         3,000	$          3,000	$        3,000	$            3,000	$          3,000	$       3,000
Incremental depreciation:
Depreciation on new machine		$         1,600	$          2,560	$        1,520	$               960	$              880	$           640
Depreciation on old machine		$             350	$             350	$            350	$               350	$              350	$           350
Incremental depreciation		$         1,250	$          2,210	$        1,170	$               610	$              530	$           290
Incremental NOI		$         3,750	$          2,790	$        3,830	$            4,390	$          4,470	$       4,710
Tax at 40%		$         1,500	$          1,116	$        1,532	$            1,756	$          1,788	$       1,884
NOPAT		$         2,250	$          1,674	$        2,298	$            2,634	$          2,682	$       2,826
Add: Incremental depreciation		$         1,250	$          2,210	$        1,170	$               610	$              530	$           290
Incremental OCF		$         3,500	$          3,884	$        3,468	$            3,244	$          3,212	$       3,116
Capital expenditure	$          8,000
Less: After tax sale value of old machine = 2500-(2500-2100)*40% =	$          2,340
Net cost of machine	$          5,660
Change in NWC = 4000-1000 =	$          3,000						$      -3,000
Incremental terminal cash flows from sale of machinery:
After tax sale of value of new machinery = 800*60% =							$           480
Less: After tax sale of value of old machinery = 500*60% =							$           300
Incremental after tax sale value							$           180
FCF	$        -8,660	$         3,500	$          3,884	$        3,468	$            3,244	$          3,212	$       6,296
PVIF at 15% [PVIF = 1/1.15^n]	1	0.86957	0.75614	0.65752	0.57175	0.49718	0.43233
PV at 15%	$        -8,660	$         3,043	$          2,937	$        2,280	$            1,855	$          1,597	$       2,722
NPV	$          5,774
As the NPV of the replacement project is positive, the replacement can be made.