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REPLACEMENT ANALYSIS The Dauten Toy Corporation currently uses an injection molding machine that was purchased 2 years ago. This machine is being depreciated on a straight-line basis, and it has 6 years of remaining life. Its current book value is $2,100, and it can be sold for $2/500 at this time. Thus, the annual depreciation expense is $2,100/6 = $350 per year. If the old machine not replaced, it can be sold for $500 at the end of its useful life.
Dauten is offered a replacement machine which has a cost of $8,000, an estimated useful life of 6 years, and an estimated salvage value of $800. This machine falls into the MACRS 5-year class so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The replacement machine would permit an output expansion, so sales would rise by $1,000 per year; even so, the new machine's much greater efficiency would cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500. Dauten's marginal federal-plus-state tax rate is 40%, and its WACC is 11%. Should it replace the old machine?
To identify: Whether a company should replace the old machine or not.
Introduction:
Replacement Analysis:
The analysis of the replacement of assets of the company is the replacement analysis. To reduce the cost of the company management takes the decision to replace the existing asset. The incremental cash flow is calculated while taking replacement decision.
Net Present Value (NPV):
NPV is the technique of capital budgeting. To select the project or not is dependent on the NPV of the project. If the project has positive NPV than accept the project if the NPV is negative than reject the project.
Given information:
For old machine
The current machine purchased 2 years ago
Depreciation is as per straight-line method.
Remaining life is 6 years.
The book value of the machine is $2,100
The market value of the old machine is $2,500.
Annual depreciation expense is $350 per year
For new machine
Life of machine is 6 years.
Earn $9000 after-tax cash flow every year.
Cost of the new machine is $8,000.
The economic life of the new machine is 10years.
Salvage value is $800.
Based on MACRS depreciation rates are 20%, 32%, 19%, 12%, 11% and 6%.
By this replacement, sales are raised by $1,000 per year.
Operating expense declined by $1,500 per year.
Inventory increases by $2,000.
Accounts payable increased by $500.
Weighted average cost of capital (WACC) is 11%.
The tax rate is 40%.
|
Year (A) |
Annual Cash flows ($) (B) |
Present value factor at 11% (C) |
Present value ($)
|
| 0 | (7,160) | 1 | (7,160) |
| 1 | 2,000 | 0.900901 | 1801.802 |
| 2 | 2,384 | 0.811622 | 1934.908 |
| 3 | 1,968 | 0.731191 | 1438.985 |
| 4 | 1,744 | 0.658731 | 1148.827 |
| 5 | 1,712 | 0.593451 | 1015.989 |
| 6 |
| 0.534641 | 1621.031 |
| NPV | 1801.541 | ||
Table (1)
Working notes:
Calculate the amount of initial investment,
| Particulars |
Amount ($) |
| Cost of new machine | 8,000 |
| Less: sale of the old machine | 2,500 |
| Add: tax paid on the sale of the old machine
| 160 |
| Add: change in net working capital | 1,500 |
| Total initial cash flow | 7,160 |
Table (2)
Calculation of depreciation tax shield,
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