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REPLACEMENT ANALYSIS The Bigbee Bottling Company is contemplating the replacement of one of its bottling machines with a newer and more efficient one. The old machine has a book value of $600,000 and a remaining useful life of 5 years. The firm does not expect to realize any return from scrapping the old machine in 5 years, but it can sell it now to another firm in the industry for $265,000. The old machine is being depreciated by $120,000 per year, using the straight-line method.
The new machine has a purchase price of $1,175,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $145,000. The applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected to economize on electric power usage, labor, and repair costs, as well as to reduce the number of defective bottles. In total, an annual savings of $255,000 will be realized if the new machine is installed. The company's marginal tax rate is 35% and it has a 12% WACC.
- a. What initial cash outlay is required for the new machine?
- b. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made.
- c. What are the incremental cash flows in Years 1 through 5?
- d. Should the firm purchase the new machine? Support your answer.
- e. In general, how would each of the following factors affect the investment decision, and how should each be treated?
- 1. The expected life of the existing machine decreases.
- 2. The WACC is not constant, but is increasing as Bigbee adds more projects into its capital budget for the year.
a.
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, the management takes decision to replace the existing asset. The incremental cash flow is calculated while taking replacement decision.
Initial Investment Outlay:
To start a business or a project, the company needs an amount, this amount is known as the initial investment outlay. It is also known as initial outlay. The amount of initial investment is calculated with the help of capital budgeting technique.
Net present Value (NPV):
NPV is the technique of capital budgeting. It is used to decide whether to accept or reject a project. If the project has positive NPV, then accept the project, if the NPV is negative, then reject the project.
Given information:
Book value of old machine is $600,000.
Remaining useful life is 5 years.
Current sale value is $265,000.
Depreciate at $ 120,000 every year using straight-line method.
New machine cost is $ 1,175,000.
Life is 5 years.
Estimated salvage value is $ 145,000.
Depreciation rate under MACRS method is 20%, 32%, 19%, 12%, 11%, and 6%.
Annual saving is $255,000.
Tax rate is 35%.
Weighted average cost of capital is 12%.
Prepare statement of initial investment outlay
| Particulars |
Amount ($) |
| Cost of new machine | 1,175,000 |
| Less: sale of old machine | 265,000 |
| Less: Tax on old machine | 117,250 |
| Total cash outlay | ... |
b.
To compute: Annual depreciation for both machines, and also the change in depreciation expense if replacement is made.
c.
To compute: The incremental cash flows.
d.
To explain: Whether the company should purchase machine or not.
e.
1.
To explain: The effect on investing decision if expected life of existing machine decreases.
2.
To explain: The effect on investing decision if the weighted average cost of capital (WACC) is not constant.
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