   Chapter 12, Problem 4P Fundamentals of Financial Manageme...

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

Solutions

Chapter
Section Fundamentals of Financial Manageme...

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

REPLACEMENT ANALYSIS The Chang Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has a book value and a market value of zero. However, the machine is in good working order and will last at least another 10 years. The proposed replacement machine will perform the operation so much more efficiently that Chang’s engineers estimate that it will produce after-tax cash flows (labor savings and depreciation) of $9,000 per year. The new machine will cost$40,000 delivered and installed, and its economic life is estimated to be 10 years. It has zero salvage value. The firm’s WACC is 10%, and its marginal tax rate is 35%. Should Chang buy the new machine?

Summary Introduction

To identify: Whether company should replace the asset 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 takes 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 depends on the NPV of the project. If the project has positive NPV, then accept the project, if the NPV is negative, then reject the project.

Explanation

Given,

The book value and the market value of old machine is zero.

Life of machine is 10years.

Earn $9000 after tax cash flow every year. Cost of new machine is$40,000.

Economic life of new machine is 10years.

Salvage value is zero.

Weighted average cost of capital (WACC) is 10%.

Marginal tax rate is 35%.

Formula to calculate net present value is,

Net present value= Present value of cash inflowPresent value of cash outflow

Substitute $55,301.4 for present value of cash inflow and$40,000 for present value of cash outflow.

Net present value=$55,301.4$40,000=\$15,301

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