Replacement Project Analysis BQC is considering replacing an old machine with a
ID: 2733140 • Letter: R
Question
Replacement Project Analysis
BQC is considering replacing an old machine with a new, more sophisticated model for a project. The new machine’s purchase price is $380,000 and an additional $20,000 will be required to install it. It will be depreciated under MACRS yielding depreciation expenses of $80,000, $128,000, $76,000, $48,000, $48,000 in years 1 through 5, respectively, leaving a salvage value of $20,000 at the end of year 5. The old machine was purchased at a cost of $240,000 three years ago and has a current book value of $69,600. Its remaining depreciation expenses under MACRS are $28,800 in year 1, $28,800 in year 2, and $12,000 in year 3 at which point it will have a book value of $0 but 2 years of useful life remaining. The firm has found a buyer willing to pay $280,000 for the present machine and remove it at the buyer’s own expense. BQC expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement. Net operating cash flows (before tax) for the new machine are expected to be $220,000 per year for the 5 years of its useful life. With the present machine, net operating cash flows of $210,000, $190,000, $170,000, $150,000 and $130,000 are expected over the next five years respectively. BQC estimates the liquidation value of the new machine at the end of its five-year useful life to be $50,000 after cleanup and removal costs. The old machine will be obsolete at the end of another 5 years and hence will have no salvage value. The $17,000 net working capital investment will be recovered at termination of the project. BQC’s federal-plus-state tax rate remains at 40% and the replacement project is of slightly below-average risk. Because of the lower risk, the project’s cost of capital is only 11.5%.
Explanation / Answer
(a) Computation of the NPV of the old machine.We have,
Step1: Computation of the present value of cash inflow.We have,
Step2: Computation of NPV of the old machine.We have,
NPV = Present value of cash inflow - Cash outflow
NPV = 404,746 - 69,600 = $ 335,146
(b) Computation of the NPV of the new machine.We have,
Step1: Computation of the present value of cash inflow.We have,
Step2: Computation of the NPV of the new machine.We have,
Cash outflow = 400,000 + 17,000 - 280,000 = $ 137,000
Present value of Salvage value = 20,000 x 0.580 = $ 11,600
Present value of recovery of working capital = 17,000 x 0.580 = $ 9,860
NPV = [ 597,013 + 11,600 + 9,860] - 137,000
NPV = $ 481,473
Since, the NPV of the new machine is greater than NPV of the old machine by $ 146,327(481,473 - 335,146).Therefore, BQC's should replace the old machine by new machine.
Year 1 2 3 4 5 Operating cash flow 210,000 190,000 170,000 150,000 130,000 Less: Depreciation 28,800 28,800 12,000 0 0 Operating cash flow after depreciation 181,200 161,200 158,000 150,000 130,000 Less: tax @40% 72,480 64,480 63,200 60,000 52,000 Earning after tax 108,720 96,720 94,800 90,000 78,000 Add: Depreciation 28,800 28,800 12,000 0 0 Cash Inflow 137,520 125,520 106,800 90,000 78,000 PVIF@11.5% 0.897 0.804 0.721 0.647 0.580 Present value of cash inflow 123,355 100,918 77,003 58,230 45,240 $ 404,746