DeYoung Entertainment Enterprises is considering replacing the latex molding mac
ID: 2745486 • Letter: D
Question
DeYoung Entertainment Enterprises is considering replacing the latex molding machine it uses to fabricate rubber chickens with a newer, more efficient model. The old machine has a book value of $450,000 and a remaining useful life of 5 years. The current machine would be worn out and worthless in 5 years, but DeYoung can sell it now to a Halloween mask manufacturer for $1 35,000. The old machine is being depreciated by $90,000 per year, using the straight-line method.
The new machine has a purchase price of $775,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $105,000. The applicable depreciation rates are 20.00%, 32.00%, 1 9.20%, 11 .52%, 11 .52%, and 5.76%. Being highly efficient, it is expected to economize on electric power usage, labor, and repair costs, and, most importantly, to reduce the number of defective chickens. In total, an annual savings of $185,000 will be realized if the new machine is installed. The company’s marginal tax rate is 35%, and it has a 12% WACC.
a) What is the initial net cash flow if the new machine is purchased and the old one is replaced?
b) Calculate the annual depreciation allowances for both machines, and compute the change in the annual depreciation expense if the replacement is made.
c) What are the incremental net cash flows in Years 1 through 5?
d) Should the firm purchase the new machine? Support your answer.
e) In general, how would each of the following factors affect the investment decision, and
how should each be treated?
The expected life of the existing machine decreases.
The WACC is not constant but is increasing as DeYoung adds more projects into its capital budget for the year.
Explanation / Answer
a) Computation of the initial net cash flow if the new machine is purchased and the old one is replaced:
New machine has a purchase price
$775,000
Less: Salvage value old machine
($135,000)
Less: Savings due to loss on sale ($450,000 – $135,000) × 0.35
($110,250)
Cash outlay for new machine
$529,750
b) Calculation of annual depreciation allowances for both machines, and compute the change in the annual depreciation expense if the replacement is made.
Year
Depreciation %
Depreciation basis
Depreciation allowance new
= Depreciation basis * depreciation %
Depreciation allowance Old
Change in old depreciation
1
20.00%
$775,000
155,000
90,000
65,000
2
32.00%
775,000
248,000
90,000
158,000
3
19.20%
775,000
148,800
90,000
58,800
4
11.52%
775,000
90,000
720
5
11.52%
775,000
89,280
90,000
720
c) What are the incremental net cash flows in Years 1 through 5?
Computation of the incremental net cash flows in Years 1 through 5:
Year
Calculation
= {(annual savings - incremental depreciation)-Tax} + incremental depreciation
Incremental cash flows
1
{($185,000-65,000) - 35%} + 65,000
143,000
2
{($185,000-158,000) - 35%} + 158,000
175,550
3
{($185,000-58,500) - 35%} + 58,500
140,725
4
{($185,000-720) - 35%} + 720
120,502
5
{($185,000-720) - 35%} + 720
120,502
d) Decision to purchase the new machine: The company should purchase the new machine as it has a positive NPV
Year
Cash flows
Present value factor @12%
Present value of cash flows
0
($529,750)
1 / (1+12%)0 =1 / 1 = 1
($529,750 )
1
{($185,000-155,000) - 35%} + 155,000 = 174,500
1 / (1+12%)1 = 0.893
155,828.5
2
{($185,000-248,000) - nill} + 248,000 = there is no tax on loss + depreciation 248,000 = 248,000
1 / (1+12%)2 = 0.797
197,656
3
{($185,000-148,800) - 35%} + 148,800 = 172330
1 / (1+12%)3 = 0.712
122,698.96
4
{($185,000-89,280) - 35%} + 89,280 = 151,498
1 / (1+12%)4 = 0.636
96,352.728
5
{($185,000-89,280) - 35%} + 89,280+ salvage value of the asset after tax= 151,498 + 105,000(1-35%) = 219,748
1 / (1+12%)5 = 0.567
124,597.116
Net present value = sum of all present value cash flows:
Calculation of Cash flows = {(annual savings - incremental depreciation)-Tax} + incremental depreciation
New machine has a purchase price
$775,000
Less: Salvage value old machine
($135,000)
Less: Savings due to loss on sale ($450,000 – $135,000) × 0.35
($110,250)
Cash outlay for new machine
$529,750
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