please answer part a A new machine is being considered as a replacement for a cu

Question

please answer part a

A new machine is being considered as a replacement for a current machine machine was purchased 12 years ago for $45,000, with an estimated life of 20 years with no salvage. Current market value is thought to be $40,000. Last year, this machine produced revenues of $25,425 while incurring cash operating expenses of $7.429, Inflation has been averaging 7% per year and revenues have been fully responsive while maintenance costs have been increasing 23% per year. Market value of the machine is expected to decline by 14% per year The current The new machine will cost $53,500. Life and salvage are unknown. Revenues will be the same as the current machine, and cash operating costs will be $5,000 the first year and increase by 11% per year. For the old machine, DDB switching to SYD after 2 years has been used. 7 Year MACRS will be used for the new machine. The tax rate is 50% on ordinary income, and 25% on capital gains. a. Use IRR techniques to find how long the current machine should be kept. b. Caleulate the rate of return for the new machine, and on the incremental (B-A) investment. Assume the new machine will last for the length of time calculated in part a, and that salvage for the current machine at that time will be equal to its market value.

Explanation / Answer

Ans:

Remaining useful life of the machine is 8 years. IRR can be computed considering the machine cost at the current market price and treating the remaining period as project life. First, compute the project cash flows for the remaining period. This is as under:

Year

0

13

14

15

16

17

18

19

20

Machine cost

40000.00

Revenue

25425.00

25425.00

25425.00

25425.00

25425.00

25425.00

25425.00

25425.00

Operating expenses

7429.00

9657.70

12555.01

16321.51

21217.97

27583.36

35858.36

46615.87

Salvage Value

11968.72

Income

17996.00

15767.30

12869.99

9103.49

4207.03

-2158.36

-10433.36

-9222.15

Depreciation

8888.89

7777.78

6666.67

5555.56

4444.44

3333.22

1111.11

0.00

Income Before Tax

9107.11

7989.52

6203.32

3547.93

-237.41

-5491.58

-11544.47

-9222.15

Tax

4553.56

3994.76

3101.66

1773.96

0.00

0.00

0.00

0.00

Income after tax

4553.56

3994.76

3101.66

1773.96

-237.41

-5491.58

-11544.47

-9222.15

Cash flow

-40000.00

13442.45

11772.54

9768.33

7329.52

4207.03

-2158.36

-10433.36

-9222.15

IRR

6%

Since maintenance cost is not given separately, it is assumed that operating expenses are on account of maintenance. The operating expenses have been calculated taking into account the inflation of 7% and incremental maintenance cost at the rate of 23% year on year.

Depreciation is computed based on SYD method considering that DDB method was used for first 2 years and for remaining period of 18 years SYD method has been considered.

Revenues have been taken at the level of previous year for entire project life considering utilization of the machine at the full capacity.

From the above calculation it is observed that cash flows are positive for a period of 5 years and thereafter, machine is unable to generate positive cash flows. The IRR is positive at 6% considering the cash flows for this period. Hence the machine can be kept for a further period of 5 years i.e. up to 17 years.

Year

0

13

14

15

16

17

18

19

20

Machine cost

40000.00

Revenue

25425.00

25425.00

25425.00

25425.00

25425.00

25425.00

25425.00

25425.00

Operating expenses

7429.00

9657.70

12555.01

16321.51

21217.97

27583.36

35858.36

46615.87

Salvage Value

11968.72

Income

17996.00

15767.30

12869.99

9103.49

4207.03

-2158.36

-10433.36

-9222.15

Depreciation

8888.89

7777.78

6666.67

5555.56

4444.44

3333.22

1111.11

0.00

Income Before Tax

9107.11

7989.52

6203.32

3547.93

-237.41

-5491.58

-11544.47

-9222.15

Tax

4553.56

3994.76

3101.66

1773.96

0.00

0.00

0.00

0.00

Income after tax

4553.56

3994.76

3101.66

1773.96

-237.41

-5491.58

-11544.47

-9222.15

Cash flow

-40000.00

13442.45

11772.54

9768.33

7329.52

4207.03

-2158.36

-10433.36

-9222.15

IRR

6%

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