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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

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 is 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 15%. Should it replace the old machine?

Summary Introduction

To identify: Whether company should replace the old machine or not.

Replacement Analysis:

The analysis of the replacement of assets of the company is the replacement analysis. To reduce the cost of the company management take 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.

Explanation

Given,

For old machine

The current using machine purchase 2 year ago

Depreciate as per straight line method, 6 year remaining life.

The book value of machine is $2100

The market value of old machine is $2500.

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 new machine is $8,000.

Economic life of 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 is decline by $1,500 per year.

Inventory increase by $2,000.

Accounts payable increase by $500.

Weighted average cost of capital (WACC) is 15%.

Tax rate is 40%.

Year

(A)

Annual Cash flows

($)

(B)

Present value factor at 15%

(C)

Present value

($)

(B)×(C)

0 (7,160) 1 (7,160)
1 2,000 0.870 1,740
2 2,384 0.756 1,802.30
3 1,968 0.658 1294.94
4 1,744 0.572 997.57
5 1,712 0.497 850.86
6 (1,552+1,480)=3,032 0.432 1309.82
NPV 835.49

Table (1)

Working notes:

Calculate amount of initial investment,

Particulars

Amount

($)

Cost of new machine 8,000
Less: sale of old machine 2,500
Add: tax paid on sale of old machine [(2,5002,100)×40%] 160
Add: change in net working capital 1,500
Total initial cash flow 7,160

Table (2)

Calculation of depreciation tax shield,

Year

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