Question

(15 pts) 8. Crowder Manufacturing, Inc. is considering the replacement of an existing machine. The new machine costs $750,000 and requires installation costs of $250,000. The existing machine can be sold currently for $300,000 before taxes. It is one year old, cost $600,000 new, and has a $500,000 book value and a remaining useful life of 5 years. Depreciation expense on the existing machine is $100,000 per year. Over its 5-year life, the new machine should reduce operating costs by $300,000 per year. The new machine will be depreciated on a straight- line basis to a zero salvage value over its 5-year life. The new machine can be sold for $100,000 net of removal and cleanup costs at the end of 5 years. An increased investment in net working capital of $100,000 will be needed to support operations if the new machine is acquired. The firm has a 16% cost of capital and is subject to a 25% tax rate. Should Crowder replace the existing machine? Show computations.

Answer 1

Solution

1 Net Initial Investment Machine Cost Instalaltion Cost Cost of New Machine $ 750,000 $ 250,000 $ 1,000,000 = 750000-250000 Sale Price of Existing Machine WDV of exixting machine Loss on Sale of exixting machine Tax Saving on Loss $ 300,000 $ 500,000 $ (200,000) = 300000-500000 $ 50,000 --200000*25% Net Initial Investment $ 650,000 = 1000000-(300000+50000) 2 Depreciation Deprecation on Existing machine (a) Deprecation on New machine (b) Incremental Deprecation (b-a) Tax Saving on Incremental Deprecation p.a $ 100,000 $ 180,000 =(1000000-100000)/5 $ 80,000 $ 20,000 =80000*25% 3 Saving in Operating Expense net of Tax per year Saving in Operating Expense per year Less: Tax on Saving Saving in Operating Expense net of Tax per year $ 300,000 $ (75,000) =300000*25% $ 225,000

Net Present Value of replacing existing machine Particular 0 1 2 3 4 5 $ (650,000) $ 20,000 $ 20,000 $ 20,000 $ 20,000 $ 20,000 $ 225,000 $ 225,000 $ 225,000 $225,000 $ 225,000 Net Initial Investment Tax Saving on Incremental Deprecation p.a Saving in Operating Expense net of Tax per year Working Capital Investment Release of Working Capital (assumed released at end of 5 year) Salvage Value of New Machine $ (100,000) $ 100,000 $ 100,000 Net Cash Flow (a) $ (750,000) $ 245,000 $ 245,000 $ 245,000 $ 245,000 $ 445,000 PV Factor @of 16% (b) 1.000 0.862 0.743 0.641 0.552 0.476 = (1/1.16)^1 =(1/1.16)^2 =(1/1.16)^3 =(1/1.16)^4 =(1/1.16)^5 Present Value (a*b) $ (750,000) $ 211,207 $ 182,075 $ 156,961 | $ 135,311 | $ 211,870 Net Present Value of replacing existing machine $ 147,425 Crowder should replace existing existing machine as NPV of replacing existing machine is positive

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