Question

Incremental Cash Flows The Supreme Shoe Company is considering the purchase of a new, fully automated machine to replace a manually operated one. The machine being replaced, now five years old, originally had an expected life of 10 years, is being depreciated using the straight-line method from $40,000 down to $0, and can now be sold for $22,000. It takes one person to operate the machine, and he earns $29,000 per year in salary and benefits. The annual costs of maintenance and defects on the old machine are $6,000 and $4,000, respectively. The replacement machine being considered has a purchase price of $75,000 and an expected salvage value of $15,000 at the end of its five-year life. There will also be shipping and installation expenses of $6,000. Because the new machine would work faster, investment in raw materials would increase by a total of $3,000. The company expects that annual maintenance costs on the new machine will be $5,000 while defects will cost $2,000. In order to purchase the new machine, the company would have to take on new debt of $30,000 at 10% interest, resulting in increased interest expense of $3,000 per year. The required rate of return for this project is 15% and the company’s marginal tax rate is 34%. Is this project acceptable? Please construct capital budgeting tables to solve the problems.

Answer 1

Let current year be "T1"
Old Machine			New Machine
Cost before 5 years	$40,000		Cost at T1	$75,000
Depreciation per year	$4,000		Shipping and Installation expenses	$6,000
			Increase in investment in Raw materials	$3,000
Depreciation for 5 years	$20,000		Maintenance	$5,000
			Defects	$2,000
Written down value at T1	$20,000		Salvage value at end of 5 years,T5	$15,000
Sale value if sold at T1	$22,000
			Debt (Interest @ 10%)	$30,000
Annual Salary	$29,000		Required rate of return	15%
Maintenance	$6,000		Company marginal tax rate	34%
Defects	$4,000
At rate of 15%,			At rate of 15%,
Present value of T5 at 10% = 3.3522			Present value of T5 at 10% = 3.3522
Annual Salary for 5 years	$97,213.8		Increase in investment in Raw materials for 5 years	$10,056.6
Maintenance for 5 years	$20,113.2		Maintenance for 5 years	$16,761
Defects cost for 5 years	$13,408.8		Defects cost for 5 years	$6,704.4
			Interst on Debt	$10,056.6
Cost from T1 to T5	$130,735.8
Oppurtunity cost of not selleing at T1	$2,000		Cost from T1 to T5	$43,578.6
Total cost	$132,735.8		Salvage value at end of T5 @ 0.4972	($7,458)
			Total cost	$36,120.6
			Total purchase cost of machine (cost + shipping expenses)	$81,000
			Total cost	$117,120.6

On comparing the total cost involved for the forthcoming 5 years between the Old machine and the New machine, it is evident that the cost of maintaining the new machine is lesser than the cost of maintaining the old machine, the project is viable,