The Trax corporation is evaluating a proposal to replace their lathe machines with a newer model that will produce more output per hour at a cheaper variable cost. The old machines have an expected life of five years with a book value of zero and a resale value of $0. The new machines will costs $2,000,000 and will require an initial working capital of $100,000 in year 0. The expected increase in output will generate $300,000 in additional sales per year. Variable costs will also be reduced by an additional $100,000 per year. The marginal tax rate for the company is 30%.
A. Use straight line depreciation. If the cost of capital is 15%, should they replace the lathe machines with the newer model? Use a five-year economic life for the machines.
B. Following up on above, assume the old lathe machines had a book value of $500,000. What would be the NPV and should the machines be replaced. What should be the before-tax salvage value in order to approve the new machines?.
C. Explain why the required rate of return increases when beta increases.