J. Mourinho Transportation Company (JMTC) is considering the purchase of a new m

ID: 2426629 • Letter: J

Question

J. Mourinho Transportation Company (JMTC) is considering the purchase of a new machine to replace the existing one to increase the productivity of the company in order to save the company from possible bankruptcy. The existing machine has a book value of $3,000 and can be sold for $4,000 in the market. The old machine is being depreciated on a straight-line basis, and its estimated salvage value 3 years from now is zero. The new machine will reduce costs (before taxes) by $7,000 per year. The new machine has a 3-year life, its price is $12,000 with an additional installation cost of $2,000, and it can be sold for an expected $2,500 at the end of the third year. The new machine would be depreciated over its 3-year life using the MACRS method. The new machine will require an increase in net operating working capital of $3,750. JMTC’s marginal tax rate is 40 percent. The company uses weight average cost of capital of 15 percent to evaluate this project. Please advise JMTC to take or to reject this replacement project. Explain your approach in 5 lines and show your work clearly.

Explanation / Answer

Evaluation of Replacement Decision:

Year 0

Year 1

Year 2

Year 3

Depreciation on old Machine (3000-0)/3

$ 1,000.00

Depreciation on New Machine (3000-0)/3

$ 4,666.20

$ 6,223.00

$ 2,073.40

(Cost = 12000+2000 =14000) * MACRS Dep rate

(14000*33.33%)

(14000*44.45%)

(14000*14.81%)

Incremental Deprecation on new machine (A)

$ 3,666.20

$ 5,223.00

$ 1,073.40

Tax Saving on incremental Depreciation = A *40% = (B) =

$ 1,466.48

$ 2,089.20

$ 429.36

Sale value of old Machine net of tax = 4000*(1-40%) (C)

$ 2,400.00

Sale value of New Machine net of tax = 2500 - ((2500 - (14000*7.41%))* 40%) = (D)

$ 1,914.96

Annual Reduction in cost net of tax = 7000* (1-40%) = (E)

$ 4,200.00

Increase in net operating working capital (F)

$ (3,750.00)

Cost of new Machine 12000+2000 = 14000 (G)

$ (14,000.00)

Net Cash Flows (CF) = B+C+D+E-F

$ (15,350.00)

$ 5,666.48

$ 6,289.20

$ 6,544.32

PVF (15%) =

1.00000

0.86957

0.75614

0.65752

PV = CF *PVF =

$ (15,350.00)

$ 4,927.37

$ 4,755.54

$ 4,303.00

NPV = Sum of PVs

$ (1,364.09)

The NPV of the replacement proposal is Negative

Hence the replacement should be rejected.