Question

8. Replacement analysis Aa Aa E Purple Whale Inc. is a company that produces iBooks, among several other products. Suppose that Purple Whale Inc. considers replacing its old machine used to make iBooks with a more efficient one, which would cost $2,000 and require $280 annually in operating costs except depreciation. After-tax salvage value of the old machine is $400, while its annual operating costs except depreciation are $1,200. Assume that, regardless of the age of the equipment, Purple Whale Inc.'s sales revenues are fixed at $2,500 and depreciation on the old machine is $400. Assume also that the tax rate is 40% and the project's risk-adjusted cost of capital, r, is the same as weighted average cost of capital (WACC) and equals 10%.

Answer 1

	0	1	2	3	4
New machine cost	$2,000
After-tax salvage value, old machine	$400
Sales Revenue		$2,500	$2,500	$2,500	$2,500
(-)Operating cost		($280)	($280)	($280)	($280)
(-)Depreciation		($667)	($889)	($296)	($148)
Operating income		$1,553	$1,331	$1,924	$2,072
(-)Tax		$621	$532	$770	$829
After tax operating income		$932	$799	$1,154	$1,243
Net cash flows after replacement (adding back depreciation)		$1,599	$1,688	$1,450	$1,391
Incremental cash flows	-$1,600	$1,599	$1,688	$1,450	$1,391

Depreciation year 1= 33.33% × 2,000 = 666.67 or 667

Year 2 = 44.45% × 2,000 = 889

Year 3 = 14.81% × 2,000 =296.2 or 296

Year 4 = 7.41% × 2,000 = 148.2 or 148