Replacement Analysis The Chang Company is considering the purchase of a new mach
ID: 2490126 • Letter: R
Question
Replacement Analysis The Chang Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has a book value and a market value of zero. However, the machine is in good working order and will last at least another 10 years. The proposed replacement machine will perform the operation so much more efficiently that Chang’s engineers estimate that it will produce after-tax cash flows (labor savings and depreciation) of $9,000 per year. The new machine will cost $40,000 delivered and installed, and its economic life is estimated to be 10 years. It has zero salvage value. The firm’s WACC is 10%, and its marginal tax rate is 35%.
Should Chang buy the new machine?
Explanation / Answer
The firm’s WACC is 10%
marginal tax rate is 35%
WACC after tax effect = wacc * (1-Tax Rate)
= 10% (1-.35)
= 6.50%
Initial Incremental Outflow = $40000
Annual Cash inflow after Tax = $9000
total Present valu of cash inflow for 10 year @ 6.50% = Sum of Present Value factor for 10 year @ 6.5% * Annual Incremental Inflow
= 7.18883 * $9000
= 64699.47
since total present value of Incremental cash inflow is $ 64699.47 is more than incremental outflow therefore company should buy the machine