You recently began working for Orange Fizz Company and management is contemplati

Question

You recently began working for Orange Fizz Company and management is contemplating the replacement of its existing, three-year old bottling machines that originally cost $6,760,000 with newer and more efficient ones. The old, existing machines, were placed on the MACRS five-year class life depreciation schedule (assuming half-year convention) three years ago. Total operating costs for the old bottling machines are $2,640,000 per year and Orange Fizz will bottle 24 million bottles per year each year for the next seven years. The firm expects to realize a $440,000 return from salvaging the old machines in 7 years; however, the existing machine may be sold now to another firm in the industry for $1,060,000. If Orange Fizz retains the old machines, they would be operational for the next 7-years.

The new machines, if purchased, would cost $7,240,000 and would be placed on a MACRS five-year class life depreciation and will be kept in operation for the next 7 years. The new machines are expected to have a salvage value of $748,000 in seven years. Total annual savings in operating costs of $1,768,000 will be realized if the new bottling machines are installed. The company is in the 40% income tax bracket and it has a 10% WACC.

Determine if the replacement should occur by estimating the replacement project’s NPV and IRR. Use a relative (incremental) cash flow analysis similar to what we did in class and in your text.

Explanation / Answer

Current cost of old mahcine 1060000 Remaining life = 7 years salvage value = 440000 Operating cost per annum= 2640000 Sales volume = 24000000 per year Purhcase cost of new machine = 7240000 salvage value new machine = 748000 Operating cost = 1768000 WACC 10% Tax rate = 40% Old machine dep = (1060000-440000)/7 = 88571.00 new machine dep = (7240000-748000)/7 = 927429.00 excess dep= 838858.00 Computation of replacement process NPV in incremental approach Step1: Computation of operating cash ouflows Particulars Amount Cost of new machine 7240000 Current cost of old machine 1060000 Excess cost 6180000 Step2: Computation of present value of savings in operating inflows Particulars Amount old machine operating cost 2640000 new machine operating cost 1768000 savings 872000 Excess dep 838858 EBT 1710858 tax @ 40% 684343.2 PAT 1026514.8 PVAF 10%, 7 years 4.869 Present value 4998100.6 STep3; Present value of terminal cash inflows Particulars Amount salvage value new machine = 748000 salvage value old= 440000 Excess salvage 308000 Less: Tax @40% 123200 After tax 184800 PVF @ 10%, 7 years 0.513 Present value 94802.4 STep4: NPV = Step2+ step3- step1 -1087097.039 NPV IS NEGATIVE SO WE CAN PROCESS Computation of replacement process IRR in incremental approach PARITUCLARS INFLOWS PVF @ 10% PVF @ 8% 0 OUTFLOW -6180000 1 -6180000 1 -6180000 .1-7 SAVINGS IN OPERATING EXP 1026514.8 4.869 4998101 5.206 5344036 7 EXCESS SALVAGE VALUE 184800 0.513 94802.4 0.583 107738.4 -1087097 -728226 IRR= OPTION 1 RATE + NPV1/ (NPV1-NPV2) * RATE2- RATE1 10+( -1087097)/ -1087097-(-728226)*(8-10) 3.942

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