Question

A small factory is considering replacing its existing coining press with a newer, more efficient one. The existing press was purchased three years ago at a cost of $510,000, and it is being fully depreciated according to a 7-year MACRS depreciation schedule and you have taken 3 years of depreciation on the old machine. The CFO estimates that the existing press has 6 years of useful life remaining. The purchase price for the new press is $675,000. The installation of the new press would cost an additional $25,000, and this cost would be capitalized and added to the depreciable base (it needs to be depreciated on the same schedule as the new press). The new press, if purchased, would be fully depreciated to a value of 0 using the 7-year MACRS depreciation schedule found below. Interest expense associated with the purchase is estimated to be roughly $12,000 per year for the next 6 years.

The appeal of the new press is that it is estimated to produce a pre-tax operating cost savings of $120,000 per year for the next 6 years, and the new press also has a useful life of 6 years. If the new press is purchased, the old press can be sold for $80,000 today. The CFO believes that the new press would be sold for $50,000 at the end of its 6- year useful life (and 6 years of depreciation). Assume that NWC would not be affected. The company had an average tax rate of 30% and has a marginal tax rate of 25% going forward. The cost of capital (i.e., discount rate) for this project is 9%.

Develop the incremental cash flows for this replacement decision and use them to calculate NPV and IRR. Next, make a conclusion about whether or not the existing coining press should be replaced at this time. Make sure that it is easy to determine how you arrived at your incremental cash flows!

Answer 1

MACRS Depreciation Schedule
Year	1	2	3	4	5	6	7	8
%	14.29%	24.49%	17.49%	12.49%	8.93%	8.92%	8.93%	4.46%
Cost of old machine	510000
Depreciation	72879	124899	89199	63699	45543	45492	45543	22746
Book value after 3 year	223023
Sale value	80000
Post tax cash inflow	115755.75
Cost of new machine	700000
Depreciation of new machine	100030	171430	122430	87430	62510	62440	62510	31220
Incremental depreciation (new yr(t)-old yr(t+3))	36331	125887	76938	41887	39764	62440	62510	31220
Salvage	50000
Book value	93730
Post tax salvage value	60932.5
Cash Flows for installation of new machine
Year	0	1	2	3	4	5	6
Cost savings		120000.00	120000.00	120000.00	120000.00	120000.00	120000.00
Interest expense		12000.00	12000.00	12000.00	12000.00	12000.00	12000.00
Incremental depreciation		36331.00	125887.00	76938.00	41887.00	39764.00	62440.00
PBT		71669.00	-17887.00	31062.00	66113.00	68236.00	45560.00
Tax @ 25%		17917.25	-4471.75	7765.50	16528.25	17059.00	11390.00
PAT		53751.75	-13415.25	23296.50	49584.75	51177.00	34170.00
Add: incremental depreciation		36331.00	125887.00	76938.00	41887.00	39764.00	62440.00
Less: initial investment	700000
Add: cash flow from sale of machine	115755.75
Add: salvage value							60932.50
Cash Flow	-584244.25	90082.75	112471.8	100234.5	91471.75	90941	157542.5
IRR	2.64%
NPV	-111691.13
Since NPV is nagative, it should not be undertaken