Question

Within the realm of capital budgeting the majority of projects are not new product lines or major corporate acquisitions. They are replacement projects or projects considered for efficiency gains. Projects taken on for efficiency gains are much less risky than new product lines or large acquisitions. A gain in efficiency or in other words a decreasing of expenses immeadetly increases net income and cash flow. It does not require one addtional item sold. Our case will review an efficiency gain capital budgeting project. Meadville Widgets is considering the purchase of a fully automated widget finishing machine to replace an older but still functioning but more labor intensive model. The machine being replaced was purchased 5 years ago for a price of $45,000.00 at which time it had an expected life of 10 years. This machine is being depreciated by the straight line method with an anticiapated salvage value of $0.00 The current market value of this machine is estimated to be $27,000.00. The current machine requires one operator with an annual cost of $37,500.00 in salary and benifits. The replacement machine has a purchase price of $79,500, a 5 year life, and an expected salvage value of $17,000. The new machine will require a 440 volt three phase electric service and a new concrete pad these installation expenses are $7,500. Meadville Widgets expect the maintence costs to be $5,000 as compared to the current costs of $6,000 and the defects to be $2,000 compared to current defect costs of $4,000. Before considering the purchase of the new machine Meadville Widgets conducted and engineering study to determine if the installation costs would be prohibitive, this study costs $5,000. In order to undertake this project the firm will add $30,000 in debt at 11.5% and the required rate of return is 15%. Meadville Widgets marginal tax rate is 34%

Answer 1

Answer:

Existing machine:

Original cost = $45,000

Annual depreciation = (cost - salvage value) / 10 = (45000 -0) /10 = $4,500

The machine was purchased 5 years ago

Accumulated depreciation = 4500 * 5 = $22,500

Book value = 45000 - 22500 = $22,500

Current market value = $27,000

Tax on gain = 34% * (27000 - 22500) = $1530

Sale proceeds net of tax = 27000 - 1530 =$25,470

Year 0 cash flows:

Initial investment = Cost of machine + Installation cost - Sale proceeds net of tax of old machine

(Engineering study cost of $5,000 is sunk cost and hence not considered)

= 79500 + 7500 - 25470

= $61,530

Year 0 to Year 5 cash flow:

Annual saving in operation cost = $37,500

Annual saving in maintenance cost = 6000 - 5000 = $1,000

Annual saving in defect costs = 4000- 2000 =$2,000

Annual depreciation of new machine = ((79500 + 7500) - 17000) / 5 = $14,000

Incremental depreciation = 14000 - 4500 = $9,500

Annual cash flow = (saving in operation cost + saving in maintenance cost + saving in defect costs) * (1 -Tax rate) + Depreciation tax shield

= (37500 + 1000 + 2000) * (1 -34%) + 9500 * 34%

= $29,960

Terminal cash flow:

Salvage value of new machine = $17,000

NPV Calculations:

NPV =Annual cash flow * PV of $1 annuity for 5 years at 15% +Terminal cash flow * PV of $1 for 5 years at 15% - Initial investment

= 29960 * (1 - 1/ (1 + 15%) ⁵) / 15% + 17000 * 1/ (1 + 15%)⁵ - 61530

= $47,352.57

NPV = $47,352.57

As NPV is positive at 47352.57, the company should go ahead with replacement.