Proposed investment in new machine $125,000 Cost of old machine (purchased 4 yea

Question

Proposed investment in new machine $125,000 Cost of old machine (purchased 4 years ago) $60,000 Estimated salvage value of old machine $40,000 Original depreciable life of old machine 8 years Estimated depreciable life of new machine 5 years Depreciation method for old machine straight line Depreciation method for new machine straight line Annual maintenance cost of old machine $25,000 Estimated annual maintenance cost of new machine $15,000 Projected annual labor savings from new machine $20,000 Corporate tax rate 34% Corporate cost of capital 12%

Explanation / Answer

Since the problem does not specify the time period over which to be evaluated the same is taken at 4 years Calculation of Cash Flows 0 1 2 3 4 Cost of New machine -125000 Incremental opeating flows 25750 25750 25750 25750 Salvage Value of Old Machine 40000 Total Cash Flows -125000 25750 25750 25750 65750 Cost of capital 12% Discount factor (=1/1.12^year) 1 0.892857 0.797194 0.71178 0.635518 Discounted Flows -125000 22991.07 20527.74 18328.34 41785.31 =cash flow *discount factor Net Present Value -21367.5 sum of discounted flows Since NPV is negative the project is not acceptable Old Machine Cost of Old Machine 60000 Estimated life 8 years Depreciation straight line Depreciation Amount 7500 Annual maintenance cost 25000 New Machine Cost of machine 125000 Depreciable life of machine 5 years Depreciation straight line Depreciation amount 25000 Annual maintenance cost 15000 Projected Annual Labour saving 20000 Calculation of incremental operating flows by replacement of old machine The below cash flow is for year 1-4. Projected annual labour saving 20000 Reduction in maintenance cost 10000 (25000-15000) Increase in Depreciation 17500 (25000-7500) Total Savings 12500 Tax 4250 34% Net Savings 8250 (12500-4250) Incremental operating flow 25750 (8250+17500)

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