eYoung Entertainment Enterprises is considering replacing the latex molding mach

Question

eYoung Entertainment Enterprises is considering replacing the latex molding machine it uses to fabricate rubber chickens with a newer, more efficient model. The old machine has a book value of $800,000 and a remaining useful life of 5 years. The current machine would be worn out and worthless in 5 years, but DeYoung can sell it now to a Halloween mask manufacturer for $265,000. The old machine is being depreciated by $160,000 per year, using the straight-line method. The new machine has a purchase price of $1,160,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $105,000. The applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. Being highly efficient, it is expected to economize on electric power usage, labor, and repair costs, and, most importantly, to reduce the number of defective chickens. In total, an annual savings of $250,000 will be realized if the new machine is installed. The company's marginal tax rate is 35%, and it has a 12% WACC. a. What is the initial net cash flow if the new machine is purchased and the old one is replaced? b. Calculate the annual depreciation allowances for both machines, and compute the change in the annual depreciation expense if the replacement is made. c. What are the incremental net cash flows in Years 1 through 5? Round your answers to the nearest dollar. d. What is the NPV?

Explanation / Answer

a. What is the initial net cash flow if the new machine is purchased and the old one is replaced?

Initial net cash flow = purchase cost of new machine - sale value of old machine

here, it was given that purchase cost of new machine = $1,160,000 and
Sale value of old machine = $265,000

Therefore, Initial net cash flow = purchase cost of new machine - sale value of old machine

= $1,160,000 - $265,000 = $895,000

b. Calculate the annual depreciation allowances for both machines, and compute the change in the annual depreciation expense if the replacement is made.

annual depreciation allowance for the old machine = $160,000 per year, using the straight-line method.

whereas, for new machine it was using MACRS class life of 5 years,
annual depreciation allowance = cost * depreciatiion percentage = $1,160,000 * 20% = 232,000 for 1st year

for 2nd year = cost * depreciatiion percentage = $1,160,000 * 32% = 371,200 for 2nd year

for 3rd year = cost * depreciatiion percentage = $1,160,000 * 19.2% = 222,720 for 3rd year

for 4th year = cost * depreciatiion percentage = $1,160,000 * 11.52% = 133,632for 4th year

for 5th yaer = cost * depreciatiion percentage = $1,160,000 * 11.52% = 133,632 for 5th year

c. What are the incremental net cash flows in Years 1 through 5?

d. What is the NPV = incremental net cash flows in Years 1 through 5 - initial cash flow

=878,526- 895,000= 16,474 negative NPV

Year income = savings in cost + salvage value- depreciation income after tax = income - tax rate @ 35% cash flows = income after tax + depreciation discounting factor @12% present value of cash flows = cash flows * discounting factor 1 250,000 - 232,000 = 18,000 18,000-35% = 11,700 11,700+232,000 = 243,700 1/(1+12%)1 = 0.893 217,624 2 250,000 - 371,200 = -121,200 -121,200 for negative cash flows no tax will be applied -121,200 + 371,200 = 250,000 1/(1+12%)2 = 0.797 199,250 3 250,000 - 222,720 = 27,280 27,280-35% = 17,732 17,732 + 222,720 = 240,452 1/(1+12%)3 = 0.712 171,202 4 250,000 - 133,632 = 116,368 116,368-35% =75,639 75,639 + 133,632 = 209,271 1/(1+12%)4 = 0.636 133,096 5 250,000 + 105,000 -133,632 = 221,368 221,368-35% = 143,889 143,889+133,632 = 277,521 1/(1+12%)5 = 0.567 157,354 incremental net cash flows in Years 1 through 5 878,526

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