Is this solution correct? NPV 44,715? WACC Purchase price Economic life Used up

Question

Is this solution correct? NPV 44,715?

WACC Purchase price Economic life Used up 10 MRK 0 MRK 5 4 12-20 REPLACEMENT ANALYSIS The Erley Equipment Company purchased a machine 5 years 5 ago at a cost of $90,000. The machine had an expected life of 10 years at the time of 6 purchase, and it is being depreciated by the straight-line method by $9,000 per year. If 7 the machine is not replaced, it can be sold for $10,000 at the end of its useful life 8 A new machine can be purchased for $150,000, including installation costs. During its 9 5-year life, it will reduce cash operating expenses by $50,000 per year. Sales are not expected 10 to change. At the end of its useful life, the machine is estimated to be worthless. MACRS 11 depreciation will be used. The machine will be depreciated over its 3-year class life rather Old Machine New Machine 90,000 150,000 8 45,000 150,000 Depreciation Old Machine New Machine 9,000 9,000 9,000 9,000 9,000 67,500 22,500 0,500 9,000) than its 5-year economic life, so the applicable depreciation rates are 33%, 45%, 15%, and 7%. 13 The old machine can be sold today for $55,000. The firm's tax rate is 35%. The 14 appropriate WACC is 16%. 15 a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0? 16 b. What are the incremental net cash flows that will occur at the end of Years 1 through 57 17 c.What is the NPV of this project? Should Erley replace the old machine? Explain. 0 Purchase new Sell Old 55,000 (10,000) 3,500 19 Rev-Costs-Depr) (1- T)+ Dep Op Tax Effect Operating CF Extra Income Expense effect Difference Depr 55,000 40,500 14,500 9,425 49,925 49,925 55,000 58,500 (3,500) 55,000 64,000 32,600 13,500 41,500 After Tax Add Depr Total CF 34,775 36,275 36,275 56,225 26,100 (98,500) 44,715

Explanation / Answer

Everything is correct, except that you missed to calculate the Loss of terminal value of old machine of $10,000 which can be fetched at the end of 5th year. Its like an opportunity cost.

Opportunity Cost / Terminal Value of old machine net of tax = $10,000 x (1 - 0.35) = $6,500

Present value of Opportunity Cost = $6500 x PVF (16%, 5th year) = $3,095

Correct NPV = 44705 - 3095 = $41,610

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