Problem:
Windschott Air Company (WAC) is a small business. It is deciding whether or not to replace an existing machine in its factory with a newer model machine. It has heard that you are a financial management student and is seeking your advice.
WAC has provided the following information for you.
The existing machine was purchased 2 years ago for $90,000 and it cost $10,000 to install. It is being depreciated over 5 years using the prime cost (straight line) method. It has a remaining useful life of 5 years. It could be sold today for $105,000 but in 5 years time it would only be worth $20,000. Over the next 5 years, earnings before depreciation and tax are expected to be $160,000 in year 1, $150,000 in year 2 and $140,000 in each of the remaining 3 years.
Last year, WAC spent $5,000 on a feasibility study of the features of the new machine. If the new machine is acquired, it will cost $145,000 to buy and $25,000 to install. It has a useful life of 5 years and will be fully depreciated over 5 years using the prime cost method. Then its resale value will be $30,000. The new machine would be expected to provide earnings before depreciation and tax of $170,000 in each of the 5 years that WAC would use it. The new machine would also lead to an increase in inventories of $10,000 and an increase in accounts receivable of $8,000. Accounts payable would increase by $5,000. Interest expense would increase by $3,000 per year as some debt finance increase would be undertaken to buy the new machine.
WAC uses a 10% hurdle rate for capital budgeting purposes. It pays tax at a rate of 40% on ordinary income and capital gains.
Advise WAC whether they should purchase the new machine and explain your reasoning to the company management. Be sure to clearly present all of your workings and calculations.