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 $450,000 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 $135,000. The old machine is being depreciated by $90,000 per year for each year of its remaining life. The new machine has a purchase price of $750,000, 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, annual pre-tax savings of $205,000 will be realized if the new machine is installed. The company's marginal tax rate is 35% and the project cost of capital is 15%.
a. What is the initial net cash flow if the new machine is purchased and the old one is replaced?
b. Calculate the annual depreciation allowances for both machines, and compute the change in the annual depreciation expense if the replacement is made.
c. What are the incremental cash flows in Year 1 through Year 5?
d. Should the firm purchase the new machine? support your answer.
NPV: $
e. In general, how would each of the following factors affect the investment decision, and how should each be treated? 1. The expected life of the existing machine decreases. If the expected life of the old machine decreases, the new machine will look (better/worse) as cash flows attributable to the new machine would (decrease/increase).
2. The WACC is not constant but is increasing as DeYoung adds more projects into its capital budget for the year. The (higher/lower) capital cost should be used in the analysis.