Holliday Manufacturing is considering the replacement of an existing machine. The new machine costs $1.2 million and requires installation costs of $150,000. The existing machine can be sold currently for $185,000 before taxes. It is a 2 year old, cost $800,000 new, and has a $384,000 book value and a remaining useful life of 5 years. It was being depreciated under MACRS using a 5-year recovery period and therefore has the final 4 years of depreciation remaining. If it is held for 5 more years, the machine's market value at the end of year 5 will be $0. Over its 5-year life, the new machine should reduce operating costs by $350,000 per year. The new machine will be depreciated under MACRS using a 5-year recovery period. The new machine can be sold for $200,000 net of removal and cleanup costs at the end of 5 years. An increased investment in net working capital of $25,000 will be needed to support operations if the new machine is acquired. Assume that the firm has adequate operating income against which to deduct any loss experienced on the sale of the existing machine. The firm has a 9% cost of capital and is subject to a 40% tax rate. a. Develop the relevant cash flows needed to analyze the proposed replacement. b. Determine the NPV of the proposal. c. Determine the IRR of the proposal. d. Make a recommendation to accept or reject the replacement proposal, and justify answer. e. What is the highest cost of capital that the firm could have and still accept the proposal? Explain.

(a)Initial investment:

Installed cost of new asset 

Cost of the new machine$1,200,000

 Installation costs150,000

Total cost of new machine$1,350,000

 After-tax proceeds from sale of old asset 

Proceeds from sale of existing machine(185,000)

 Tax on sale of existing machine*(79,600)

Total after-tax proceeds from sale (264,600)

 Increase in net working capital25,000

Initial investment$1,110,400

*Book value $384,000

$185,000  $384,000  $199,000 loss from sale of existing press

$199,000 loss from sale(0.40) $79,600

Calculation of Operating Cash Flows
New Machine
Year / Reduction in
Operating Costs /
Depreciation / Net Profits
Before Taxes /
Taxes / Net Profits
After Taxes / Cash
Flow
1 / $350,000 / $270,000 / $80,000 / $32,000 / $48,000 / $318,000
2 / 350,000 / 432,000 / 82,000 / 32,800 / 49,200 / 382,800
3 / 350,000 / 256,500 / 93,500 / 37,400 / 56,100 / 312,600
4 / 350,000 / 162,000 / 188,000 / 75,200 / 112,800 / 274,800
5 / 350,000 / 162,000 / 188,000 / 75,200 / 112,800 / 274,800
6 / 0 / 67,500 / 67,500 / 27,000 / 40,500 / 27,000
Existing Machine
Year /
Depreciation / Net Profits
Before Taxes /
Taxes / Net Profits
After Taxes / Cash
Flow
1 / $152,000 / $152,000 / $60,800 / $91,200 / $60,800
2 / 96,000 / 96,000 / 38,400 / 57,600 / 38,400
3 / 96,000 / 96,000 / 38,400 / 57,600 / 38,400
4 / 40,000 / 40,000 / 16,000 / 24,000 / 16,000
5 / 0 / 0 / 0 / 0 / 0
6 / 0 / 0 / 0 / 0 / 0
Incremental Operating Cash Flows
Year / New Machine / Existing Machine / Incremental Cash Flow
1 / $318,000 / $60,800 / $257,200
2 / 382,800 / 38,400 / 344,400
3 / 312,600 / 38,400 / 274,200
4 / 274,800 / 16,000 / 258,800
5 / 274,800 / 0 / 274,800
6 / 27,000 / 0 / 27,000

Terminal cash flow:

After-tax proceeds from sale of new asset 

Proceeds from sale of new asset$200,000

 Tax on sale of new asset *(53,000)

Total proceeds-sale of new asset$147,000

 After-tax proceeds from sale of old asset0

 Change in net working capital25,000

Terminal cash flow$172,000

*Book value of new machine at the end of year 5 is $67,500

200,000  $67,500 $132,500 income from sale of old machine

132,500  0.40 $53,000 tax liability

(b)

Year / CF / PVIF9%,n / PV
1 / $257,200 / 0.917 / $235,852
2 / 344,400 / 0.842 / 289,985
3 / 274,200 / 0.772 / 211,682
4 / 258,800 / 0.708 / 183,230
5 / 274,800 / 0.650 / 178,620
Terminal value / 172,000 / 0.650 / 111,800
$1,211,169

NPV PV of cash inflows  Initial investment

NPV $1,211,169  $1,110,400

NPV $100,769

Calculator solution: $100,900

(c)

IRR 12.2%

Calculator solution: 12.24%

(d)Since the NPV  0 and the IRR  cost of capital, the new machine should be purchased.

(e)12.24%. The criterion is that the IRR must equal or exceed the cost of capital; therefore, 12.24% is the lowest acceptable IRR.