A company is considering replacing one of the old machines used in the manufactu

Question

A company is considering replacing one of the old machines used in the manufacturing process. The machine was purchased 2 years ago for $500,000. This machine is being depreciated on a straight-line basis, and it has 4 yrs of remaining life. When this machine was purchased 2 yrs ago, it was to have zero salvage value at the end of 6 yrs. Currently , this machine has a market value of $250,000. The company intends to keep this old machine as spare if the replacement happens. The current revenue generated by this machine is $250,000 and the cost of operating the machine is $175,000 annually.

The replacement machine will cost of $860,000 and $40,000 for shipping. The new machine falls into 3-yr MACRS (33% , 45%, 15 % and 7%). The replacement machine would permit an output expansion, so sales will become $350,000 per yr. Even so, the new machine would cause operating expenses to become $95,000 per year. The new machine would require inventories to be increased by $65,000 , accounts payable increase by $9000. The replacement project life is 5yrs. The new machine can be sold at the end of its projects life for $45,000 while the old machine will not have any value at the end of its 5th year. Tax rate is 40%, and its cost of capital is 12%.

What is the initial investment CF0?

What is cash flow CF1 to be used in NPV calculations?

Explanation / Answer

1)Increase in net working capital = Increase in inventory - Increase in accounts payable

                  = 65000 - 9000

                 = 56000

Capitalized cost of machine = 860000 +40000 = 900000

since the old machine will not be sold if replaced there will be no cash outflow .

CF0 = capitalized cost + working capital investment

       = 900000 +56000

      = $ 956000

b)

Increase in revenue [350000-250000] 100000 Decrease in operating cost [175000- 95000] 80000 increase in expense Depreciation on replaced machine [900000*.33] (297000) Depreciation on old machine [500000/6] (83333.33) Income before tax (200333.33) Tax [-200333.33*.40] 80133.33 Net income 120200 depreciation [297000+83333.33] 380333.33 Cash flow for year 1[CF1] 500533.33

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