DeYoung Entertainment Enterprises is considering replacing the latex molding mac
ID: 2764841 • 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 $800,000 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 $265,000. The old machine is being depreciated by $160,000 per year, using the straight-line method. The new machine has a purchase price of $1,160,000, 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%, 19.20%, 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 $250,000 will be realized if the new machine is installed. The company's marginal tax rate is 35%, and it has a 12% WACC. What is the initial net cash flow if the new machine is purchased and the old one is replaced? What are the incremental net cash flows in Years 1 through 5? Round your answers to the nearest dollar.
Explanation / Answer
Year
Dep (new)
Dep (old)
Change in Depreciation
1
$ 232,000
$ 160,000
$ 72,000
2
$ 371,200
$ 160,000
$ 211,200
3
$ 222,720
$ 160,000
$ 62,720
4
$ 133,632
$ 160,000
$ (26,368)
5
$ 133,632
$ 160,000
$ (26,368)
Changes in cash flow: (Changes in Savings-Changes in Cost- Changes in Depreciation)(1-tax)+Changes in Depreciation
Changes in Savings=250000
Year
Change in Depreciation
Changes in saving
Marginal tax rates
1-tax
Change in cash flows
Change in cash flows
1
$ 72,000
$ 250,000
0.35
0.65
(250000-72000)(1-.35)+72000
$ 281,300
2
$ 211,200
$ 250,000
0.35
0.65
(250000-211200)(1-.35)+211200
$ 510,980
3
$ 62,720
$ 250,000
0.35
0.65
(250000-62720)(1-.35)+62720
$ 265,988
4
$ (26,368)
$ 250,000
0.35
0.65
(250000+26368)(1-.35)-26368
$ 118,993
5
$ (26,368)
$ 250,000
0.35
0.65
(250000+26368)(1-.35)-26368
$ 118,993
Cash outflow in first year
Cash Outflow=Cost of new machine-proceeds from selling of old machine
Net proceed from selling of old machine=Market Value-Tax rate(Market Value-Book Value)
Net proceed from selling of old machine=265000-.35(265000-800000)
Net proceed from selling of old machine=$452,250
Cash Outflow=$1,160,000-$452,250=$707,750
Year
Dep (new)
Dep (old)
Change in Depreciation
1
$ 232,000
$ 160,000
$ 72,000
2
$ 371,200
$ 160,000
$ 211,200
3
$ 222,720
$ 160,000
$ 62,720
4
$ 133,632
$ 160,000
$ (26,368)
5
$ 133,632
$ 160,000
$ (26,368)
Changes in cash flow: (Changes in Savings-Changes in Cost- Changes in Depreciation)(1-tax)+Changes in Depreciation
Changes in Savings=250000
Year
Change in Depreciation
Changes in saving
Marginal tax rates
1-tax
Change in cash flows
Change in cash flows
1
$ 72,000
$ 250,000
0.35
0.65
(250000-72000)(1-.35)+72000
$ 281,300
2
$ 211,200
$ 250,000
0.35
0.65
(250000-211200)(1-.35)+211200
$ 510,980
3
$ 62,720
$ 250,000
0.35
0.65
(250000-62720)(1-.35)+62720
$ 265,988
4
$ (26,368)
$ 250,000
0.35
0.65
(250000+26368)(1-.35)-26368
$ 118,993
5
$ (26,368)
$ 250,000
0.35
0.65
(250000+26368)(1-.35)-26368
$ 118,993
Cash outflow in first year
Cash Outflow=Cost of new machine-proceeds from selling of old machine
Net proceed from selling of old machine=Market Value-Tax rate(Market Value-Book Value)
Net proceed from selling of old machine=265000-.35(265000-800000)
Net proceed from selling of old machine=$452,250
Cash Outflow=$1,160,000-$452,250=$707,750
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