Question

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 $650,000 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 $295,000. The old machine is being depreciated by $130,000 per year, using the straight-line method. The new machine has a purchase price of $1,100,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $155,000. 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 $235,000 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? Cash outflow should be indicated by a minus sign. Round your answer to the nearest dollar. b. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made. Depreciation allowances should be entered as positive values. Negative change values, if any, should be indicated by a minus sign. Round your answers to the nearest dollar. Year Depreciation Depreciation Change in Allowance, Allowance, Old Depreciation New c. What are the incremental net cash flows in Years 1 through 5? Round your answers to the nearest dollar. Year 1 Year 2 Year 3 Year 4 Year 5 d. Should the firm purchase the new machine? Select 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. The new machine will look -Select- than before due to the relative -Select- of the cash flows attributable to it. -Select- should be made. 2. The WACC is not constant but is increasing as Bigbee adds more projects into its capital budget for the year. The NPV will -Select- due to a -Select- capital cost.

Answer 1

a. Calculation of initial cash flow = Purchase price of New Machine - Sale price of Old Machine

= $1100000 - $ 295000 = $805000

b. Calculation of Depreciation allowance:

Year	New Depreciation	Old Depreciation	Change
1	220000	130000	90000
2	281600	130000	151600
3	113696	130000	-16304
4	58164	130000	-71836
5	46919	130000	-83081

c. Incremental Net Cash Flow

Year	Savings	Tax on Depreciation @35%	Net cash flow
1	235000	31500	266500
2	235000	53060	288060
3	235000	-5706	229294
4	235000	-25142	209858
5	235000	-29078	205922

d. Since Net cash in flow is more than Net cash outflow the New machine should be purchased:

Cash inflow	PV Factor @ 12%	Net Present value
266500	0.89	237946
288060	0.80	229640
229294	0.71	163207
209858	0.64	133368
205922	0.57	116846
	Total inflow	881007
	Outflow	805000
	NPV	76007