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Fundamentals of Financial Manageme...

8th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285065137

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

8th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285065137
Textbook Problem

REPLACEMENT ANALYSIS The Erley Equipment Company purchased a machine 5 years ago at a cost of $90,000. 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 $9,000 per year. If the machine is not replaced, it can be sold for $10,000 at the end of its useful life.

A new machine can be purchased for $150,000, including installation costs. During its 5-year life, it will reduce cash operating expenses by $50,000 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 35%. The appropriate WACC is 16%.

  1. a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0?
  2. b. What are the incremental cash flows that will occur at the end of Years 1 through 5?
  3. c. What is the NPV of this project? Should Erley replace the old machine? Explain.

a.

Summary Introduction

To compute: Initial cash outlay from new machine.

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.

Explanation

Given,

Book value of old machine is $90,000.

Remaining useful life is 10 years.

Estimated salvage value is $10,000.

Depreciate at $ 9000 every year using straight line method.

The old machine can be sold today at $55,000.

New machine cost is $ 150,000.

Life is 5 years.

Depreciation rate under MACRS method is 33%, 45%, 15%, and 7%.

Annual saving is $50,000.

Tax rate is 35%.

Weighted average cost of capital is 16%.

Prepare statement of initial investment outlay.

Particulars

Amount

($)

Cost of new machine 150,000
Less: Sale of old machine 55,000
Less: Tax on old machine 12,250
Total cash outlay

b.

Summary Introduction

To compute: The incremental cash flows.

c.

Summary Introduction

To compute: The NPV of the project and whether the company should select the new machine or not.

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