Question

A small factory is considering replacing an existing machine with a newer, more efficient one. Research and development costs associated with the replacement decision were $40,000 last year (2015). The existing machine was purchased three years ago at a cost of $230,000, and it is being fully depreciated according to a 5-year MACRs depreciation schedule. The current book value reflects that the firm has taken three years of depreciation. Because the company actively maintains its machinery and equipment, the CFO estimates that the existing machine has 6 years of useful life remaining. The purchase price for the new machine is $410,000. The installation of the new machine would cost an additional $30,000, which should be added to the depreciable base according to our accountants. The new machine (if purchased) would be fully depreciated using the 5-year MACRs depreciation schedule.

With the old machine, the factory produced and sold 20,000 units. This was the plant capacity. The new machine will increase plant capacity to 25,000 units; however the marketing department estimates potential client sales at 22,000 units per year for the next six years. Each unit sells for $90. With the increased productivity of the new system, the variable costs will remain at $50 per unit. The appeal of the new machine is that it is estimated to produce a pre-tax operating cost savings of $30,000 per year for the next 6 years. Also, if the new machine is purchased, the old machine can be sold for $30,000 today. The CFO believes that the new machine would be sold for $48,000 at the end of its 6-year useful life.

With the additional sales, the company will need to make additional investments in Net Working Capital (NWC) to support the increased operations. In particular, the increase in NWC (at time t) is expected to be 10% of incremental sales between time t and time t+1. Thus, the NWC investments at t=0 would be 10% of the projected sales for t=1. Additional NWC investments would be required to support any further increases in sales and the cumulative investments in NWC made as a result of this project would be recovered at the project's end. The company has an average tax rate of 28% and a marginal tax rate of 33%. The cost of capital (i.e., discount rate) for this project is 14%.

Develop the incremental cash flows for this replacement decision. Make sure to clearly identify (1) incremental operating cash flows, (2) NWC cash flows, (3) net capital spending, and (4) the free cashflow. Then calculate the project's NPV, IRR, MIRR and payback period. Finally, offer a recommendation about whether or not the existing machine should be replaced at this time.

Answer 1

	NOTE: Research and Development cost of $40,000 is a sunk cost and not relevant for this analysis
	DEPRECIATION OF EXISTING MACHINE
	Year From Date of Purchase	1	2	3	4	5	6
	Cost of machine	$230,000
	Year From Today				1	2	3	4	5	6
A	Depreciation Rate(5 Year MACRS)	20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
D1=230000*A	Annual Depreciation expense	$46,000	$73,600	$44,160	$26,496	$26,496	$13,248	$0	$0	$0
	Accumulated Depreciation	$46,000	$119,600	$163,760	$190,256	$216,752	$230,000	$230,000	$230,000
	Salvage Value			$30,000
	Book Value today	$66,240	(230000-163760)
	Salvage Value today(Before tax)	$30,000
	Loss onSalvage	$36,240
	Tax Saving on loss=33%*36240	$11,959
	After tax salvage value today=30000+11959	$41,959
	Salvage value (Before tax) at end of year 6	$0
	After tax salvage value at end of year 6	$0
	DEPRECIATION OF NEW MACHINE
	Year(from today)	1	2	3	4	5	6
	Depreciable cost =410000+30000	$440,000
A	Depreciation Rate	20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
D2=A*440000	Depreciation amount	$88,000	$140,800	$84,480	$50,688	$50,688	$25,344
	Accumulated Depreciation	$88,000	$228,800	$313,280	$363,968	$414,656	$440,000
	Book Value at end of year 6	$0
	Before tax Salvage Value at end of year6	$48,000
	Gain on Salvage	$48,000
	Tax on gain =33%*48000	$15,840
	After Tax Salvage Value	$32,160	(48000-15840)