You recently began working for Orange Fizz Company and management is contemplating the replacement of its existing, three-year old bottling machines that originally cost $6,760,000 with newer and more efficient ones. The old, existing machines, were placed on the MACRS five-year class life depreciation schedule (assuming half-year convention) three years ago. Total operating costs for the old bottling machines are $2,640,000 per year and Orange Fizz will bottle 24 million bottles per year each year for the next seven years. The firm expects to realize a $440,000 return from salvaging the old machines in 7 years; however, the existing machine may be sold now to another firm in the industry for $1,060,000. If Orange Fizz retains the old machines, they would be operational for the next 7-years.
The new machines, if purchased, would cost $7,240,000 and would be placed on a MACRS five-year class life depreciation and will be kept in operation for the next 7 years. The new machines are expected to have a salvage value of $748,000 in seven years. Total annual savings in operating costs of $1,768,000 will be realized if the new bottling machines are installed. The company is in the 40% income tax bracket and it has a 10% WACC.
Determine if the replacement should occur by estimating the replacement project’s NPV and IRR. Use a relative (incremental) cash flow analysis similar to what we did in class and in your text.