### Replacement analysis

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##### Reference no: EM13216

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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