Question

REPLACEMENT ANALYSIS

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 $600,000 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 $235,000. The old machine is being depreciated by $120,000 per year, using the straight-line method.

The new machine has a purchase price of $1,125,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $150,000. 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 $210,000 will be realized if the new machine is installed. The company's marginal tax rate is 35%, and it has a 12% WACC.

1. What initial cash outlay is required for the new machine? Round your answer to the nearest dollar. Negative amount should be indicated by a minus sign.
   $
   
2. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made. Round your answers to the nearest dollar.

   Year	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation
   1	$	$	$
   2
   3
   4
   5

3. 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
   $	$	$	$	$

4. Should the firm purchase the new machine?
   -Select-YesNo

Answer 1

a.

Initial outlay for new machine = Cost of new machine - After tax sale value of old machine

Sale value of old machine	235000
Book value of old machine	600000
loss on sale	365000
tax benefit on loss	127750
Inflow on old asset (235000+127750)	362750
Cost of new machine	1125000
Initial Cash Outlay (1125000-362750)	762250

b.

New Depreciation is calculated at the MACRS rate of 20%, 32%, 19%, 12% and 11% for 5 years and old depreciation is given at 120000 per year for next 5 years.

Year	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation	Tax Benefit on additional depreciation @35%
1	225000	120000	105000	36750
2	360000	120000	240000	84000
3	213750	120000	93750	32812.5
4	135000	120000	15000	5250
5	123750	120000	3750	1312.5

c.

Year	1	2	3	4	5
Annual savings	210000	210000	210000	210000	210000
Tax@35% on Annual savings	-73500	-73500	-73500	-73500	-73500
Tax saving due to additional depreciation	36750	84000	32812.5	5250	1312.5
Salvage value of new machine					125000
Less: book value of new machine (remaining 6%)					67500
Taxable salavage value					57500
Tax on salvage value @ 35%					-20125
Terminal year cash flow (125000-20125)					104875
Incremental net cash flows	173250	220500	169312.5	141750	242687.5

d.

Calculation of Net Present Value

Year	1	2	3	4	5
Incremental net cash flows	173,250.00	220,500.00	169,312.50	141,750.00	242,687.50
Present value factor @ 12%	0.892857	0.797194	0.711780	0.635518	0.567427
Present Value	154,687.50	175,781.25	120,513.29	90,084.69	137,707.41
Total Present Value	678,774.14
Less: Initial cash outlay	(762,250.00)
Net Present Value	(83,475.86)

Because the net present value is negative firm should not purchase the new machine. No