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REPLACEMENT ANALYSIS The Darlington Equipment Company purchased a machine 5 years ago at a cost of $85,000. The machine had an expected life of 10 years at the time of purchase, and it is being depreciated by the straight-line method by $8,500 per year. If the machine is not replaced, it can be sold for $15,000 at the end of its useful life.
A new machine can be purchased for $170,000, including installation costs. During its 5-year life, it will reduce cash operating expenses by $40,000 per year. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worthless. MACRS depreciation will be used, and the machine will be depreciated over its 3-year class life rather than its 5-year economic life; so the applicable depreciation rates are 33%, 45%, 15%, and 7%.
The old machine can be sold today for $55,000. The firm's tax rate is 40%. The appropriate WACC is 9%.
- a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0?
- b. What are the incremental cash flows that will occur at the end of Years 1 through 5?
- c. What is the NPV of this project? Should Darlington replace the old machine? Explain.
a.
To compute: Initial cash outlay from the new machine.
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, take the decision to replace the existing asset. The incremental cash flow is calculated while taking replacement decision.
Given information:
The book value of the old machine is $42,500.
Remaining useful life is 5 years.
Estimated salvage value is $15,000.
Depreciate at $ 8,500 every year using straight-line method.
The old machine can be sold today at $55,000.
New machine cost is $ 170,000.
Life is 5 years.
Depreciation rate under MACRS method is 33%, 45%, 15%, and 7%.
Annual saving is $40,000.
The tax rate is 40%.
Weighted average cost of capital is 9%.
Prepare a statement of initial investment outlay.
| Particulars |
Amount ($) |
| Cost of new machine | 170,000 |
| Less: Sale of old machine | 55,000 |
| Add: Tax on Sale of old machine | 5,000 |
| Total cash outlay | ...
b.
To compute: The incremental cash flows.
c.
To compute: The NPV of the project and whether the company should select the new machine or not.
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