Question

Problem 11-13
Replacement Analysis

The Everly Equipment Company's flange-lipping machine was purchased 5 years ago for $90,000. It had an expected life of 10 years when it was bought and is being depreciated by the straight-line method by $9,000 per year. As the older flange-lippers are robust and useful machines, it can be sold for $20,000 at the end of its useful life.

A new high-efficiency digital-controlled flange-lipper can be purchased for $130,000, including installation costs. During its 5-year life, it will reduce cash operating expenses by $55,000 per year, although it will not affect sales. At the end of its useful life, the high-efficiency machine is estimated to be worthless. MACRS depreciation will be used, and the machine will be depreciated over its 3-year class life rather than its 5-year economic life, so the applicable depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%.

The old machine can be sold today for $50,000. The firm's tax rate is 35%, and the appropriate WACC is 15%.

1. If the new flange-lipper is purchased, what is the amount of the initial cash flow at Year 0? Round your answer to the nearest whole dollar.
   $   
2. 
   
3. 
   
4. 
   
5. What are the incremental net cash flows that will occur at the end of Years 1 through 5? Round your answers to the nearest whole dollar.

   CF1	$
   CF2	$
   CF3	$
   CF4	$
   CF5	$

6. 
   
7. What is the NPV of this project? Round your answer to the nearest whole dollar.
   $    
   
   Should Everly replace the flange-lipper?

Answer 1

a)	Cost of the new flange lipper		$    1,30,000
	Sale value of the old machine	$       50,000
	Book value of the old machine = 90000-9000*5 =	$       45,000
	Gain on sale	$         5,000
	Tax on gain = 5000*35% =	$         1,750
	After tax cash flow from sale of old machine = 50000-1750 =		$       48,250
	Amount of initial cash flow at Year 0		$       81,750
b)		0	1	2	3	4	5
	Savings in cash operating expenses		$       55,000	$        55,000	$     55,000	$    55,000	$       55,000
	Incremental depreciation:
	Depreciation of new machine		$       43,329	$        57,785	$     19,253	$      9,633
	Depreciation of old machine		$          9,000	$          9,000	$        9,000	$      9,000	$         9,000
	Incremental depreciation		$       34,329	$        48,785	$     10,253	$          633	$        -9,000
	Incremental NOI		$       20,671	$          6,215	$     44,747	$    54,367	$       64,000
	Tax at 35%		$          7,235	$          2,175	$     15,661	$    19,028	$       22,400
	Incremental NOPAT		$       13,436	$          4,040	$     29,086	$    35,339	$       41,600
	Add: Depreciation		$       34,329	$        48,785	$     10,253	$          633	$        -9,000
	Incremental OCF		$       47,765	$        52,825	$     39,339	$    35,972	$       32,600
	Incremental sale value of equipment:
	After tax sale value of new equipment =						$                -
	After tax sale value of the old equipment = 20000*(1-35%)=						$       13,000
	Incremental after tax sale value						$     -13,000
	Incremental net cash flows		$       47,765	$        52,825	$     39,339	$    35,972	$       19,600
c)	PVIF at 15% [PVIF = 1/1.15^n]		0.86957	0.75614	0.65752	0.57175	0.49718
	PV at 15%		$       41,535	$        39,943	$     25,866	$    20,567	$         9,745
	Sum of PVs of cash flows t1 to t5	$   1,37,655
	Less: Initial investment	$       81,750
	NPV	$       55,905
	Everly should replace the flange lipper as the NPV of replacement is positive.