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 $625,000 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 $265,000. The old machine is being depreciated by $125,000 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 $140,000. 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 $225,000 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-Yes or No
   
   Support your answer. The input in the box below will not be graded, but may be reviewed and considered by your instructor.
   
5. 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 input in the box below will not be graded, but may be reviewed and considered by your instructor.

   2. The WACC is not constant, but is increasing as Bigbee adds more projects into its capital budget for the year.

   The input in the box below will not be graded, but may be reviewed and considered by your instructor.

Answer 1

Part b)

Year	Dep Allow New	Dep Allow Old	Change in depreciation (Dep Allow New-Old)
1	(1,125,000-140,000)*20% = 197,000	125,000	72,000
2	(1,125,000-140,000)*32% = 315,200	125,000	190,200
3	(1,125,000-140,000)*19% = 187,150	125,000	62,150
4	(1,125,000-140,000)*12% = 118,200	125,000	-6,800
5	(1,125,000-140,000)*11% = 108,350	125,000	-16,650

Part a, c & d)

Sl.No	Year	0	1	2	3	4	5
	Initial Outlay
i	Purchase of new machine (Given)	-1,125,000
ii	Sale of old machine (Given)	265,000
iii	Net initial outlay (i+ii) (part A)	-860,000
	Incremental net cash flows
iv	Annual savings if new machine is installed (Given)		225,000	225,000	225,000	225,000	225,000
v	Change in depreciation (refer part b)		72,000	190,200	62,150	-6,800	-16,650
vi	Incremental profit before tax (iv-v)		153,000	34,800	162,850	231,800	241,650
vii	Taxes @ 35% (vi*35%)		53,550	12,180	56,998	81,130	84,578
viii	Incremental profit after tax (vi-vii)		99,450	22,620	105,853	150,670	157,073
ix	Add back: change in depreciation (v)		72,000	190,200	62,150	-6,800	-16,650
x	Incremental net cash flows (viii+ix) (Part c)		171,450	212,820	168,003	143,870	140,423
	Terminal cash flows
xi	Salvage value of new machine (Given)						140,000
xii	Net cash flows (iii+x+xi)	-860,000	171,450	212,820	168,003	143,870	280,423
xiii	PVF @ 12% 1/[1.12^year]	1	0.8929	0.7972	0.7118	0.6355	0.5674
xiv	Discounted cash flows (xii*xiii)	-860,000	153,088	169,660	119,584	91,429	159,112

Part d) Net present value of replacement = ΣDiscounted cash flows = -167,127

Since NPV is negative, so the firm should not purchase new machine.