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d. Should the machine be purchased? Explain your answer 12-10 REPLACEMENT ANALYS

ID: 2580517 • Letter: D

Question

d. Should the machine be purchased? Explain your answer 12-10 REPLACEMENT ANALYSIS T he Dauten Toy Corporation currently uses an injection mol machine that was purchased 2 years ago. This machine is being depreciated on a straight-line basis, and it has 6 years of remaining life. Its current book value is $2,100, and it can be for $2,500 at this time. Thus, the annual depreciation expense is $2,100/6- $350 per year,Ie sold the old machine is not replaced, it can be sold for $500 at the end of its useful life. Dauten is offered a replacement machine which has a cost of $8,000, an estimated useful life of 6 years, and an estimated salvage value of $800. This machine falls into the MACRS 5-year class so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%, The replacement machine would permit an output expansion, so sales would rise by $1,000 per year; even so, the new machine's much greater efficiency would cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500. Dauten's marginal federal-plus-state tax rate is 40%, and its WACC is 11%. Should it replace the old machine?

Explanation / Answer

First determine the net cash flow at t = 0:

Purchase price ($8,000)

Sale of old machine 2,500

Tax on sale of old machine (160)a

Change in net working capital (1,500)b

Total investment ($7,160)

a The market value is $2,500 – $2,100 = $400 above the book value. Thus, there is a $400 recapture o fdepreciation, and the company would have to pay 0.40($400) = $160 in taxes.

b The change in net working capital is a $2,000 increase in current assets minus a $500 increase in currentliabilities, which totals to $1,500

Annual cash inflows:

Sales increase $1,000

Cost decrease 1,500

Increase in pre-tax revenues $2,500

After-tax revenue increase:

2,500(1 – T) = $2,500(0.60) = $1,50

Depreciation:

Thus NPV = $1,908.47. As NPV is >0 the replacement should be done.

Calculations:

PVIF = 1/(1+11%)^n where n is the year of the cash flow

PV = cash flow amount*PVIF

NPV = sum of all PVs

Year 1 2 3 4 5 6 New 1,600.00 2,560.00 1,520.00 960.00 880.00 480.00 Old 350.00 350.00 350.00 350.00 350.00 350.00 Change 1,250.00 2,210.00 1,170.00 610.00 530.00 130.00 Depreciation tax savings 500.00 884.00 468.00 244.00 212.00 52.00