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%. Based on the data, net cash flows (NCFs) before replacement are $940 , and they are constant over four years. Although Purple Whale Inc.'s NCFs before replacement are the same over the four-year period, its NCFs after replacement vary annually. The following table shows depreciation rates over four years. Year 1 Year 2 Year 3 Year 4 Depreciation rates 33.33% 44.45% 14.81% 7.41% Complete the following table and calculate incremental cash flows in each year. Hint: Round your answers to the nearest dollar and remember to enter a minus sign if the calculated value is negative. Year 1 Year 2 Year 3 Year 4 Year 0 $2,000 $400 New machine cost After-tax salvage value, old machine Sales revenues Operating costs except depreciation Operating income After-tax operating income Net cash flows after replacement (adding back depreciation) Incremental Cash Flows $ O $ $ $2,500 $280 1,553 $ 932 $ 1,599 $ $2,500 $280 1,331 $ 799 $ 1,688 $ $2,500 $280 2,072 $2,500 $280 1,924 $ 1,154 $ 1,450 $ 1,391 $ 1,600 $ 1,599 $ 1,688 $ 1,450 $ 1,391
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Answer 1

Based on the equation, replacing the old equipment appears to be a Good decision because the Npv of the project is positive.