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Replacement analysis
Course:- Financial Management
Reference No.:- EM13216




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The Dauten Toy Corporation currently uses an injection molding machine that was purchased 2 years ago.  This machine is being depreciated on a straight-line basis, and it has 6 years of remaining life.  Its current book value is $2,100, and it can be sold for $2,500 at this time. Thus, the annual depreciation expense is $2,100/6 = $350 per year.  If the old machine is not replaced, it can be sold for $500 at the end of its useful  life.

 Dauten is offered a replacement machine which has a cost of $8,000, an estimated useful life of 6 years, and an estimated salvage value of $800. This machine falls into the MACRS 5-year class so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. the replacement machine would permit an output expansion, so sales would rise by $1,000 per  year; even so, the new machine's much greater efficiency would cause operating expenses to decline by $1,500 per year. the new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500. Dauten's marginal federal-plus-state tax rate is 40%, and its WACC is 15%. Should it replace the old machine?

Here we have the calculation to find the solution.











Net cash flow at t = 0:
















Purchase price
 





Sale of old machine
 





Tax on sale of old machine  





Change in net working capital  





Total investment
 















Annual cash inflows:
















Sales increase
 





Cost decrease
 





Pre-tax revenue increase  





Tax benefit
 





After-tax revenue increase  















Depreciation:










Year 1 Year 2 Year 3 Year 4


New

       


Old

       


Change

       












Depreciation tax savings        






















Calculate NPV:




















Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Net investment
             
After-tax revenue increase              
Depreciation tax savings              
Working capital recovery              
Salvage value of new machine              
Tax on salvage value              
Opportunity cost of old machine              
Project cash flows
             










NPV =   







Replace old machine (Yes/No)?  








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