Question

Integrative Investment decision Holday Manufacturing is considering the replacement of an existing machine. The new machine costs $1.27 million and requires installation costs of $153,000. The existing machine can be sold currently for $193,000 before taxes. It is 2 years old, cost $794,000 new, and has a $381,120 book value and a remaining useful life of 5 years. It was being depreciated under MACRS using a 5-year recovery period EE and therefore h the final 4 years of depreciation remaining. If it is held for 5 more years, the machine's market value at the end of year 5 will be $0. Over its 5-year life, the new machine should reduce operating costs by $349,000 per year. The new mach will be depreciated under MACRS using a 5-year recovery period. The new machine can be sold for S199,000 net of removal and cleanup costs at the end of 5 years. An increased investment in net working capital of $24,000 wi be neec to support operations if the new machine is acquired Assume that the firm has adequate operating income against which to deduct any loss experienced on the sale of the existing machine. The firm has a 9.4% cost of capital and is sub to a 40% tax rate a. Develop the net cash flows needed to analyze the proposed replacement. b. Determine the net present value (NPV) of the proposal. c. Determine the internal rate of return (IRR) of the proposal. d. Make a recommendation to accept or reject the replacement proposal, and justify your answer e. What is the highest cost of capital that the firm could have and still accept the proposal? Data Table Click on the icon located on the top-right corner of the data table below in order to copy its contents into a spreadsheet.) a. Develop the relevant cash flows needed to analyze the proposed replacement. Calculate the initial investment: (Round to the nearest dollar.) Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property Classes Cost of the new machine Installation cost Installed cost of new asset Proceeds from sale of existing machine$ Tax on sale of existing machine Total after-tax proceeds from sale Increase in net working capital Percentage by recovery year Recovery year years 33% 45% 15% 5 years 20% 32% 19% 12% 12% 5% 7 years 14% 25% 18% 12% 9% 10 years 10% 18% 14% 12% 9% 8% 9% 4% Initial investmant 10 Enter any number in the edit fields and then click Check Answer 4% 100% Totals 100% 100% 100%

Answer 1

a)	Cost of the new machine	1270000
	Installation cost	153000
	Installed cost of new asset		1423000
	Proceeds from sale of existing machine	193000
	Tax shield on sale of existing machine	75248
	Total after tax proceeds from sale		-268248
	Increase in net working capital		24000
	Initial investment		1178752
	Operating cash flows:	0	1	2	3	4	5
	Savings in operating costs		349000	349000	349000	349000	349000
	Incremental depreciation:
	Depreciation on new machine		284600	455360	270370	170760	170760	71150	1423000
	Depreciation on old machine		150860	95280	95280	39700	0	412880	794000
	Incremental depreciation		133740	360080	175090	131060	170760
	Net savings before tax		215260	-11080	173910	217940	178240
	Tax at 40%		86104	-4432	69564	87176	71296
	Incremental NOPAT		129156	-6648	104346	130764	106944
	Add: Incremental depreciation		133740	360080	175090	131060	170760
	Annual OCF		262896	353432	279436	261824	277704
	Terminal non operating cash flows:
	Salvage value of new machine		199000
	Book value	71150
	Gain	127850
	Tax at 40%		51140
	After tax salvage value of new machine		147860
	After tax salvage value of old machine		0
	Release of NWC		24000
			171860
b)	NPV:
	Annual OCF		262896	353432	279436	261824	277704
	Initial investment	1178752
	Terminal non operating cash flows						-171860
	Annual project cash flows	-1178752	262896	353432	279436	261824	449564
	PVIF at 9.4% (PVIF = 1/1.094^n)	1	0.91408	0.83554	0.76374	0.69812	0.63814
	PV at 9.4%	-1178752	240307	295305	213418	182785	286883	39946
	NPV	39946
c)	IRR is that discount rate for which NPV is 0. This has to be found out by trial and error by applying different
	discount rates to get 0 NPV.
	PVIF at 11%	1	0.90090	0.81162	0.73119	0.65873	0.59345
	PV at 11%	-1178752	236843	286853	204321	172472	266794	-11468
	The IRR lies between 9.4% and 11%. The value of IRR, by simple interpolation, is:
	IRR = 9.4+1.6*39946/(39946+11468) =	10.64%
d)	As the NPV is positive, the replacement can be made.
e)	Highest cost of capital possible = IRR = 10.64%.
	This will give 0 NPV.