Miami Vice Inc., a manufacturer of processed rice products, is considering the r
ID: 2626740 • Letter: M
Question
Miami Vice Inc., a manufacturer of processed rice products, is considering the replacement of one of its milling machines. Ron Johnson, vice president finance, has compiled all available data concerning the old machine and the one to replace it. The old machine was purchased 3 years ago at a capital cost of $130,000 and is currently valued at $50,000. It is expected to last a further 8 years at which time it would be buried on the company%u2019s property for a flat fee of $2,000 paid to the city of Montreal.
The new machine, according to the brochure sent over by the saleswoman, has a manufacturer%u2019s suggested retail price of $275,000, including installation and transportation. Johnson has been told however that Miami Rice could obtain the machine at 15% discount but would have to pay a document preparation fee of $1,000. This new machine is expected to last 8 years at which time it could be sold for $15,000. Thomas Michael Philip, plant engineer, has suggested that the new machine not be sold at the end of 8 years but that it is kept as a spare machine to be used in the event of the breakdown of another machine. Johnson thinks this is an excellent idea.
Johnson has received two sets of cash flow estimates concerning the replacement of the old machine. One set of estimates, submitted by Ricardo Crocket, a very junior financial analyst at the company, indicates net pre-tax annual cash flows of $47,000. Sonny Tubbs, a highly experienced analyst, has submitted an estimated 50% above Crocket%u2019s. Johnson feels that Tubbs%u2019 estimate is more reliable but that Crocket%u2019s estimate has considered some things left out by Tubbs. In fact, Johnson feels that Tubbs%u2019 estimate has a 75% chance of being right, while Crocket%u2019s estimate has only a 25% chance of being right.
Both the old and new milling machines belong to the class 2 asset pool which has a declining balance CCA rate of 15%. The company has a policy of balance in class 2 will always be positive and that there will always be assets remaining in the class. The firm%u2019s cost of capital is 10% and its tax rate is 40%. A bank loan arranged at the local bank would cost the company 12% per annum. If the company took out this loan, its leverage would be higher.
Question: Should the old milling machine be replaced?
Explanation / Answer
Old machine CCA Depreciation rate 15% Particular/Year 0 1 2 3 4 5 6 7 8 9 10 11 12 Tax rate 40% Asset value 130000 Cost of capital 10% Current value (old) 50000 42500 36125 30706 26100 22185 18857 16029 13625 Cost of debt (loan) for the new machine 12% Depreciation on old machine 7500 6375 5419 4606 3915 3328 2829 2404 2044 Current value (new) 234750 199538 169607 144166 122541 104160 88536 75255 63967 Depreciation on new machine 35212.5 29931 25441 21625 18381 15624 13280 11288 9595 Incremental depreciation 27713 23556 20022 17019 14466 12296 10452 8884 7551 New machine Estimate of pre-tax annual cash flows Proability List price 275000 Ricardo Crocket 47000 25% Discount @ 15% 41250 Sonny Tubbs 70500 75% Documentation fees 1000 Net cost 234750 Expected pre-tax annual cash flows 64625 Actual year (for discounting) 0 1 2 3 4 5 6 7 8 Particular/Year 0 1 2 3 4 5 6 7 8 9 10 11 Incremental Pre-tax annual cash flows (EBITDA) 64625 64625 64625 64625 64625 64625 64625 64625 Incremental depreciation 27713 23556 20022 17019 14466 12296 10452 8884 EBIT 36913 41069 44603 47606 50159 52329 54173 55741 EBIT*(1-t) 22148 24642 26762 28564 30095 31397 32504 33445 Add: Incremental depreciation 27713 23556 20022 17019 14466 12296 10452 8884 Incremental operating cash flows 49860 48197 46784 45583 44561 43693 42956 42329 Investment in new machine -234750 Salvage value from old machine 50000 Salvage value from new machine 15000 Lee: tax on profit on sale of new machine -19587 SAVINGS ON BURIAL OF OLD MACHINE (Post- tax) 1200 Total cash flows -184750 49860 48197 46784 45583 44561 43693 42956 78115 Discounted cash flows -184750 45327.27 39832.44 35149.45 31133.51 27669.15 24663.83 22043.07 36441.44 NPV 77510.15 Since the NPV is positive, it is advisable to replace the old machine