Question

Problem 11-14
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 $600,000 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 $265,000. The old machine is being depreciated by $120,000 per year for each year of its remaining life.

The new machine has a purchase price of $1,160,000, 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 $255,000 will be realized if the new machine is installed. The company's marginal tax rate is 35% and the project cost of capital is 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.
   $
2. 
   
3. 
   
4. 
   
5. 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.

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

6. 
   
7. What are the incremental net cash flows in Years 1 through 5? Do not round intermediate calculations. Round your answers to the nearest dollar.

   CF1	$
   CF2	$
   CF3	$
   CF4	$
   CF5	$

8. 
   
9. Should the firm purchase the new machine?
   -Select-YesNoItem 22
   
   Support your answer. Do not round intermediate calculations. Round your answer to the nearest dollar.
   
   NPV: $

Answer 1

Time line		0	1	2	3	4	5
Proceeds from sale of existing asset	=selling price* ( 1 -tax rate)	172250
Tax shield on existing asset book value	=Book value * tax rate	210000
Cost of new machine		-1160000
=a. Initial Investment outlay		-777750
5 years MACR rate			20.00%	32.00%	19.20%	11.52%	11.5200%	0.0576	0
Profits			255000	255000	255000	255000	255000
-Depreciation (answer b -e)	=Cost of machine*MACR%		-232000	-371200	-222720	-133632	-133632	66816	=Salvage Value
=Pretax cash flows			23000	-116200	32280	121368	121368
-taxes	=(Pretax cash flows)*(1-tax)		14950	-75530	20982	78889.2	78889.2
+Depreciation			232000	371200	222720	133632	133632
=after tax operating cash flow			246950	295670	243702	212521.2	212521.2
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						68250
+Tax shield on salvage book value	=Salvage value * tax rate						23385.6
=Terminal year after tax cash flows							91635.6
g. Total Cash flow for the period		-777750	246950	295670	243702	212521.2	304156.8
Discount factor=	(1+discount rate)^corresponding period	1	1.15	1.3225	1.520875	1.7490063	2.0113572
Discounted CF=	Cashflow/discount factor	-777750	214739.13	223568.998	160238.02	121509.69	151219.68
NPV=	Sum of discounted CF=	93525.5201

Buy replacement as NPV is positive