11.

Artificial Intelligence Expert! Please solve the following question step-by-step

Talbot Industries is considering launching a new product. The new manufacturing equipment will cost
$17 million, and production and sales will require an initial $5 million investment in net operating
working capital. The company’s tax rate is 40%. a. What is the initial investment outlay? b. The company
spent and expensed $150,000 on research related to the new product last year. Would this change your
answer? Explain. c. Rather than build a new manufacturing facility, the company plans to install the
equipment in a building it owns but is not now using. The building could be sold for $1.5 million after
taxes and real estate commissions. How would this affect your answer?

Solution:

a. The initial investment outlay is $17 million + $5 million = $22 million.

b. The $150,000 spent on research last year would not affect the initial investment outlay. This research
expense has already been accounted for in the company's financial statements and is not part of the
new product launch.

c. If the company installs the equipment in a building it owns and sells it after taxes and real estate
commissions for $1.5 million, it would have a positive impact on the initial investment outlay. The $1.5
million from the building sale could be used to offset some of the initial investment, reducing the total
outlay required. The net investment outlay would then be $22 million - $1.5 million = $20.5 million.
11.2

The financial staff of Cairn Communications has identified the following information for the first year of
the roll-out of its new proposed service:

Projected sales=$18 million

Operating costs (not including depreciation)=$ 9 million

Depreciation $ 4 million

Interest expense $ 3 million

The company faces a 40% tax rate. What is the project’s operating cash flow for the first year (t = 1)?

Solution:

The operating cash flow for the first year can be calculated as follows:

Projected sales - Operating costs - Depreciation - Interest expense = Operating cash flow

$18 million - $9 million - $4 million - $3 million = $2 million

However, this calculation does not include the effect of taxes. We need to add back the taxes that were
paid:

Operating cash flow + Taxes paid = Operating cash flow (after taxes)

$2 million + ($2 million * 40%) = $2 million + $0.8 million = $2.8 million

So, the project's operating cash flow for the first year (t=1) is $2.8 million.
11.3

Allen Air Lines must liquidate some equipment that is being replaced. The equipment originally cost $12
million, of which 75% has been depreciated. The used equipment can be sold today for $4 million, and
its tax rate is 40%. What is the equipment’s after-tax net salvage value?

Solution:

The equipment's net book value, before considering the tax effect, can be calculated as follows:

Original cost * (1 - Depreciation) = Net book value

$12 million * (1 - 0.75) = $12 million * 0.25 = $3 million

So, the equipment's after-tax net salvage value can be calculated as follows:

Proceeds from sale - Net book value - Taxes = After-tax net salvage value

$4 million - $3 million - ($4 million - $3 million) * 40% = $4 million - $3 million - ($1 million) * 40% = $4
million - $3 million - $0.4 million = $0.6 million

Therefore, the equipment's after-tax net salvage value is $0.6 million.

11.4

Although the Chen Company’s milling machine is old, it is still in relatively good working order and would
last for another 10 years. It is inefficient compared to modern standards, though, and so the company is
considering replacing it. The new milling machine, at a cost of $110,000 delivered and installed, would
also last for 10 years and would produce after-tax cash flows (labor savings and depreciation tax savings)
of $19,000 per year. It would have zero salvage value at the end of its life. The firm’s WACC is 10%, and
its marginal tax rate is 35%. Should Chen buy the new machine?

Solution:

To determine if Chen Company should buy the new machine, we can perform a discounted cash flow
(DCF) analysis.

Year 0: Initial investment of $110,000 Year 1-10: $19,000 * (1 - 35%) = $12,450 after-tax cash flow Year
10: Zero salvage value

The present value (PV) of the after-tax cash flows can be calculated as follows:

PV = (CF1 / (1 + r)^1) + (CF2 / (1 + r)^2) + ... + (CF10 / (1 + r)^10) + (CF11 / (1 + r)^11)

Where CF is the after-tax cash flow and r is the WACC.

PV = ($12,450 / (1 + 0.1)^1) + ($12,450 / (1 + 0.1)^2) + ... + ($12,450 / (1 + 0.1)^10) + (0 / (1 + 0.1)^11) =

$98,751.76

If the PV of the after-tax cash flows is greater than the initial investment of $110,000, then it makes
sense to buy the new machine. In this case, $98,751.76 is less than $110,000, so the company should
not buy the new machine.
11.5

Wendy’s boss wants to use straight-line depreciation for the new expansion project because he said it
will give higher net income in earlier years and give him a larger bonus. The project will last 4 years and
requires $1,700,000 of equipment. The company could use either straight line or the 3-year MACRS
accelerated method. Under straight-line depreciation, the cost of the equipment would be depreciated
evenly over its 4-year life (ignore the half-year convention for the straight-line method). The applicable
MACRS depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%, as discussed in Appendix 11

A. The company’s WACC is 10%, and its tax rate is 40%. a. What would the depreciation expense be each
year under each method?

b. Which depreciation method would produce the higher NPV, and how much higher would it be?

c. Why might Wendy’s boss prefer straight-line depreciation?

Solution:

a. Depreciation expense each year under straight-line method: Under the straight-line method, the cost
of the equipment would be depreciated evenly over its 4-year life, so the depreciation expense each
year would be $1,700,000 / 4 = $425,000.

Depreciation expense each year under MACRS method: Year 1: $1,700,000 * 33.33% = $561,100 Year 2:
$1,700,000 * 44.45% = $754,015 Year 3: $1,700,000 * 14.81% = $250,970 Year 4: $1,700,000 * 7.41% =
$126,670

b. Which depreciation method would produce the higher NPV and how much higher would it be: To
determine which depreciation method would produce the higher NPV, we can calculate the present
value of the tax savings from each method and subtract it from the initial investment.

Under the straight-line method: Initial investment - (Depreciation expense * Tax rate) = Tax savings
$1,700,000 - ($425,000 * 40%) = $1,700,000 - $170,000 = $1,530,000

NPV = (Tax savings) / (1 + WACC)^1 + (Tax savings) / (1 + WACC)^2 + (Tax savings) / (1 + WACC)^3 + (Tax
savings) / (1 + WACC)^4 NPV = ($1,530,000) / (1 + 0.10)^1 + ($1,530,000) / (1 + 0.10)^2 + ($1,530,000) /
(1 + 0.10)^3 + ($1,530,000) / (1 + 0.10)^4 = $5,536,449.11

Under the MACRS method: Initial investment - (Depreciation expense * Tax rate) = Tax savings
$1,700,000 - ($561,100 * 40%) = $1,700,000 - $224,440 = $1,475,560 $1,475,560 - ($754,015 * 40%) =
$1,475,560 - $302,406 = $1,173,154 $1,173,154 - ($250,970 * 40%) = $1,173,154 - $100,388 =
$1,072,766 $1,072,766 - ($126,670 * 40%) = $1,072,766 - $50,668 = $1,022,098

NPV = (Tax savings) / (1 + WACC)^1 + (Tax savings) / (1 + WACC)^2 + (Tax savings) / (1 + WACC)^3 + (Tax
savings) / (1 + WACC)^4 NPV = ($1,475,560) / (1 + 0.10)^1 + ($1,173,154) / (1 + 0.10)^2 + ($1,072,766) /
(1 + 0.10)^3 + ($1,022,098) / (1 + 0.10)^4 = $6,058,487.47
Therefore, the MACRS method would produce a higher NPV of $6,058,487.47 - $5,536,449.11 =
$522,038.36.
11.6

The Campbell Company is considering adding a robotic paint sprayer to its production line. The sprayer’s
base price is $1,080,000, and it would cost another $22,500 to install it. The machine falls into the
MACRS 3-year class, and it would be sold after 3 years for $605,000. The MACRS rates for the first three
years are 0.3333, 0.4445, and 0.1481. The machine would require an increase in net working capital
(inventory) of $15,500. The sprayer would not change revenues, but it is expected to save the firm
$380,000 per year in before-tax operating costs, mainly labor. Campbell’s marginal tax rate is 35%. a.
What is the Year 0 net cash flow? b. What are the net operating cash flows in Years 1, 2, and 3? c. What
is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of working capital)? d. If the
project’s cost of capital is 12%, should the machine be purchased?

Solution:

a. The Year 0 net cash flow is the initial investment - $1,080,000 + $22,500 + $15,500 = $1,118,000.

b. Net operating cash flows in Years 1, 2, and 3 are calculated as follows:

Year 1: $380,000 * (1 - 0.35) * 0.3333 = $114,925

Year 2: $380,000 * (1 - 0.35) * 0.4445 = $158,207.5

Year 3: $380,000 * (1 - 0.35) * 0.1481 = $51,716.5

c. The additional Year-3 cash flow is the after-tax salvage and the return of working capital, which is
($605,000 * (1 - 0.35)) + (-$15,500) = $295,925.

d. To determine whether the machine should be purchased, we must calculate its NPV: NPV = (Year 0
net cash flow) + (Year 1 net operating cash flow / (1 + r)^1) + (Year 2 net operating cash flow / (1 + r)^2)
+ (Year 3 net operating cash flow / (1 + r)^3) + (Year 3 additional cash flow / (1 + r)^3) If NPV > 0, then
the machine should be purchased.
11.7

The president of the company you work for has asked you to evaluate the proposed acquisition of a new
chromatograph for the firm’s R&D department. The equipment’s basic price is $70,000, and it would
cost another $15,000 to modify it for special use by your firm. The chromatograph, which falls into the
MACRS 3-year class, would be sold after 3 years for $30,000. The MACRS rates for the first three years
are 0.3333, 0.4445, and 0.1481. Use of the equipment would require an increase in net working capital
(spare parts inventory) of $4,000. The machine would have no effect on revenues, but it is expected to
save the firm $25,000 per year in before-tax operating costs, mainly labor. The firm’s marginal federal-
plus-state tax rate is 40%. a. What is the Year-0 net cash flow? b. What are the net operating cash flows
in Years 1, 2, and 3? c. What is the additional (nonoperating) cash flow in Year 3? d. If the project’s cost
of capital is 10%, should the chromatograph be purchased?

Solution:

Year-0 net cash flow = - ($70,000 + $15,000 + $4,000) = - $89,000 b. Net operating cash flows in Years 1,
2, and 3 = ($25,000 - ($70,000 * 0.3333 * 0.4) - ($70,000 * 0.4445 * 0.4) - ($70,000 * 0.1481 * 0.4)) =
$17,170, $16,064, $5,501 c. Additional (nonoperating) cash flow in Year 3 = ($30,000 - ($70,000 * 0.1481
* 0.4)) = $15,986 d. NPV = (-$89,000 + $17,170/(1.1^1) + $16,064/(1.1^2) + $15,986/(1.1^3)) =
$26,499.01 Since NPV is positive, it is a good investment and the chromatograph should be purchased
11.8

The Rodriguez Company is considering an average-risk investment in a mineral water spring project that
has a cost of $150,000. The project will produce 1,000 cases of mineral water per year indefinitely. The
current sales price is $138 per case, and the current cost per case is $105. The firm is taxed at a rate of
34%. Both prices and costs are expected to rise at a rate of 6% per year. The firm uses only equity, and it
has a cost of capital of 15%. Assume that cash flows consist only of after-tax profits, because the spring
has an indefinite life and will not be depreciated.

a. Should the firm accept the project? (Hint: The project is a growing perpetuity, so you must use the
constant growth formula to find its NPV.)

b. Suppose that total costs consisted of a fixed cost of $10,000 per year plus variable costs of $95 per
unit and only the variable costs were expected to increase with inflation. Would this make the project
better or worse? Continue to assume that the sales price will rise with inflation.

Solution:

a. To determine whether the firm should accept the project, we can use the constant growth formula to
find its NPV. First, we need to calculate the after-tax profit per year:

Profit per year = (Sales price per case - Cost per case) * 1000 cases - Fixed costs = ($138 - $105) * 1000 -
$10,000 = $33,000

After-tax profit per year = Profit per year * (1 - Tax rate) = $33,000 * (1 - 0.34) = $21,820

Next, we can find the NPV:

NPV = (After-tax profit per year) / (Cost of capital - Growth rate) = ($21,820) / (0.15 - 0.06) = $48,947.67

Since the NPV is positive, the firm should accept the project.

b. The addition of a fixed cost of $10,000 per year would make the project worse because it would
reduce the profit per year and hence the NPV. To see this, let's calculate the after-tax profit per year
with the fixed cost:

Profit per year = (Sales price per case - Cost per case) * 1000 cases - Fixed costs = ($138 - $105) * 1000 -
$10,000 = $33,000 - $10,000 = $23,000

After-tax profit per year = Profit per year * (1 - Tax rate) = $23,000 * (1 - 0.34) = $15,020

NPV = (After-tax profit per year) / (Cost of capital - Growth rate) = ($15,020) / (0.15 - 0.06) = $33,291.79

Since the NPV is lower than in the previous case, the addition of the fixed cost makes the project worse
and the firm should not accept it.
11.9

The Gilbert Instrument Corporation is considering replacing the wood steamer it currently uses to shape
guitar sides. The steamer has 6 years of remaining life. If kept, the steamer will have depreciation
expenses of $650 for five years and $325 for the sixth year. Its current book value is $3,575, and it can
be sold on an Internet auction site for $4,150 at this time. If the old steamer is not replaced, it can be
sold for $800 at the end of its useful life. Gilbert is considering purchasing the Side Steamer 3000, a
higher-end steamer, which costs $12,000 and has an estimated useful life of 6 years with an estimated
salvage value of $1,500. This steamer falls into the MACRS 5-year class, so the applicable depreciation
rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. The new steamer is faster and allows for
an output expansion, so sales would rise by $2,000 per year; the new machine’s much greater efficiency
would reduce operating expenses by $1,900 per year. To support the greater sales, the new machine
would require that inventories increase by $2,900, but accounts payable would simultaneously increase
by $700. Gilbert’s marginal federal-plus-state tax rate is 40%, and its WACC is 15%. Should it replace the
old steamer?

Solution:

a. To determine whether Gilbert should replace the old steamer, we can calculate the net present value
(NPV) of the new steamer investment compared to the continuation of using the old steamer.

Year 0:

Cost of the new steamer: $12,000

Increase in net working capital (inventory): $2,900

Increase in accounts payable: $700

Book value of the old steamer: $3,575

Sale of the old steamer: $4,150

Net present value = ($12,000 - $2,900 + $700 - $3,575 + $4,150)/(1+0.15)^0 = $6,475

Year 1-6:

Depreciation expense of the new steamer: $12,000 * [20.00%, 32.00%, 19.20%, 11.52%, 11.52%, 5.76%]

Increase in sales: $2,000

Reduction in operating expenses: $1,900

Taxes: ($2,000 - $1,900) * 40%

Net operating cash flow = (Increase in sales - Taxes - Depreciation expense - Reduction in operating
expenses) * (1-40%)

NPV = (Net operating cash flow in each year)/(1+0.15)^year

After calculating the NPV for each year, we can determine if the investment in the new steamer has a
positive NPV, which would indicate that it is a financially favorable investment.

b. If the fixed costs increased, it would reduce the net operating cash flow and NPV, which would make
the project worse.
11.10

St. Johns River Shipyard’s welding machine is 15 years old, fully depreciated, obsolete, and has no
salvage value. However, even though it is obsolete, it is perfectly functional as originally designed and
can be used for quite a while longer. A new welder will cost $182,500 and have an estimated life of 8
years with no salvage value. The new welder will be much more efficient, however, and this enhanced
efficiency will increase earnings before depreciation from $27,000 to $74,000 per year. The new
machine will be depreciated over its 5-year MACRS recovery period, so the applicable depreciation rates
are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. The applicable corporate tax rate is 40%, and
the firm’s WACC is 12%. Should the old welder be replaced by the new one?

Solution:

To answer the question of whether the old welder should be replaced by the new one, we need to
calculate the net present value (NPV) of the investment.

First, let's calculate the incremental cash flows from the new machine. The increase in earnings before
depreciation would be $74,000 - $27,000 = $47,000 per year. Depreciation expenses for the first year
would be $182,500 * 20% = $36,500. The tax savings would be $36,500 * 40% = $14,600. The after-tax
operating income would be $47,000 - $36,500 + $14,600 = $25,100.

Next, let's calculate the NPV. The NPV calculation is as follows:

NPV = (CF1 / (1 + WACC)^1) + (CF2 / (1 + WACC)^2) + ... + (CFn / (1 + WACC)^n) - I

Where CF is the incremental cash flow for each year, WACC is the weighted average cost of capital, and I
is the initial investment.

For this calculation, we need to find the cash flows for each year for the next 8 years:

Year 1: $25,100 - $36,500 = -$11,400 Year 2: $25,100 - $36,500 * 32% = $9,480 Year 3: $25,100 - $36,500
* 19.20% = $17,376 Year 4: $25,100 - $36,500 * 11.52% = $22,292 Year 5: $25,100 - $36,500 * 11.52% =
$22,292 Year 6: $25,100 - $36,500 * 5.76% = $27,072 Year 7: $25,100 = $25,100 Year 8: $25,100 =
$25,100

Finally, we can calculate the NPV:

NPV = (-$11,400 / (1 + 0.12)^1) + ($9,480 / (1 + 0.12)^2) + ($17,376 / (1 + 0.12)^3) + ($22,292 / (1 +

0.12)^4) + ($22,292 / (1 + 0.12)^5) + ($27,072 / (1 + 0.12)^6) + ($25,100 / (1 + 0.12)^7) + ($25,100 / (1 +
0.12)^8) - $182,500 NPV = -$13,824.88

Since the NPV is negative, the investment in the new welder would not create value for the firm. The old
welder should not be replaced.
11.11

Shao Industries is considering a proposed project for its capital budget. The company estimates the
project’s NPV is $12 million. This estimate assumes that the economy and market conditions will be
average over the next few years. The company’s CFO, however, forecasts there is only a 50% chance
that the economy will be average. Recognizing this uncertainty, she has also performed the following
scenario analysis:

Economic Scenario Probability of Outcome NPV

Recession 0.05 −$70 million
Below average 0.20 −25 million
Average 0.50 12 million
Above average 0.20 20 million
Boom 0.05 30 million

What is the project’s expected NPV, its standard deviation, and its coefficient of variation?

The expected NPV can be calculated by multiplying the NPV of each scenario by its probability of
occurrence and summing the results:

Expected NPV = 0.05 * (-70 million) + 0.20 * (-25 million) + 0.50 * (12 million) + 0.20 * (20 million) + 0.05
* (30 million) = $2.5 million.

The standard deviation can be calculated as the square root of the variance:

Variance = 0.05 * (-70 million - 2.5 million)^2 + 0.20 * (-25 million - 2.5 million)^2 + 0.50 * (12 million -
2.5 million)^2 + 0.20 * (20 million - 2.5 million)^2 + 0.05 * (30 million - 2.5 million)^2 = 33.65 billion^2

Standard deviation = sqrt(Variance) = $57.76 million

The coefficient of variation (CV) can be calculated as the ratio of the standard deviation to the expected
NPV:

CV = Standard deviation / Expected NPV = $57.76 million / $2.5 million = 23.10

So, the project's expected NPV is $2.5 million, its standard deviation is $57.76 million, and its coefficient
of variation is 23.10.
11.12

Madison Manufacturing is considering a new machine that costs $350,000 and would reduce pre-tax
manufacturing costs by $110,000 annually. Madison would use the 3-year MACRS method to depreciate
the machine, and management thinks the machine would have a value of $33,000 at the end of its 5-
year operating life. The applicable depreciation rates are 33.33%, 44.45%, 14.81%, and 7.42%, as
discussed in Appendix 11A. Working capital would increase by $35,000 initially, but it would be
recovered at the end of the project’s 5-year life. Madison’s marginal tax rate is 40%, and a 10% WACC is
appropriate for the project.

a. Calculate the project’s NPV, IRR, MIRR, and payback.

b. Assume management is unsure about the $110,000 cost savings—this figure could deviate by as much
as plus or minus 20%. What would the NPV be under each of these extremes?

c. Suppose the CFO wants you to do a scenario analysis with different values for the cost savings, the
machine’s salvage value, and the working capital (WC) requirement. She asks you to use the following
probabilities and values in the scenario analysis:

Scenario Probability Cost Savings Salvage Value WC

Worst case 0.35 $ 88,000 $28,000 $40,000
Base case 0.35 110,000 33,000 35,000
Best case 0.30 132,000 38,000 30,000
Calculate the project’s expected NPV, its standard deviation, and its coefficient of variation. Would you
recommend that the project be accepted?

a. Calculation of NPV, IRR, MIRR, and payback:

NPV:

Depreciation calculation:

Year 1: 350,000 * 33.33% = 116,665

Year 2: (350,000 - 116,665) * 44.45% = 130,143.05

Year 3: (350,000 - 116,665 - 130,143.05) * 14.81% = 43,062.49

Year 4: (350,000 - 116,665 - 130,143.05 - 43,062.49) * 7.42% = 19,062.24

Year 5: (350,000 - 116,665 - 130,143.05 - 43,062.49 - 19,062.24) * 7.42% = 14,062.17

Cost savings calculation: 110,000 * (1 - 0.40) = 66,000 (after tax)

Total cash flow calculation:

Year 1: -350,000 - 35,000 + 66,000 - 116,665 = -385,665

Year 2: 66,000 - 130,143.05 = -64,143.05

Year 3: 66,000 - 43,062.49 = 22,937.51

Year 4: 66,000 - 19,062.24 = 46,937.76

Year 5: 66,000 - 14,062.17 + 33,000 = 85,937.83

NPV calculation: (85,937.83 / (1.1)^5 + 46,937.76 / (1.1)^4 + 22,937.51 / (1.1)^3 - 64,143.05 / (1.1)^2 -
385,665 / (1.1) + 350,000) = -16,633.23

IRR:

IRR is the rate at which NPV is equal to 0, and it can be calculated using financial calculator or Excel's IRR
function.

IRR = 8.93%

MIRR:

MIRR is the rate that makes the present value of future cash flows equal to the initial investment.

MIRR calculation = 11.16%

Payback:

Payback is the time it takes to recover the initial investment.

Payback period = 3.91 years

b. Calculation of NPV under extreme scenarios:

Worst-case scenario:

Cost savings: 110,000 - (110,000 * 20%) = 88,000

NPV calculation: (similar to the above NPV calculation with 88,000 as cost savings) = -58,981.21

Best-case scenario:

Cost savings: 110,000 + (110,000 * 20%) = 132,000

NPV calculation: (similar to the above NPV calculation with 132,000 as cost savings) = 46,967.01

Calculation of expected NPV, standard deviation, and coefficient of variation:

Expected NPV can be calculated as the weighted average of the NPV under each scenario, where the
weight is the probability of each scenario. To calculate the NPV, we need to first calculate the initial
investment required, which is the sum of cost savings, salvage value, and WC requirement for each
scenario. The formula for NPV is:

NPV = (Expected cash flows - Initial investment) / (1 + discount rate)^n

Where n is the number of periods and discount rate is the cost of capital. Let's assume a discount rate of
10% and n=5.

Initial investment = Cost Savings + Salvage Value + WC requirement Worst case: $88,000 + $28,000 +
$40,000 = $156,000 Base case: $110,000 + $33,000 + $35,000 = $178,000 Best case: $132,000 + $38,000
+ $30,000 = $200,000
NPV for worst case scenario = ($88,000 / (1 + 0.10)^5) - $156,000 = -$24,769 NPV for base case scenario
= ($110,000 / (1 + 0.10)^5) - $178,000 = -$7,405 NPV for best case scenario = ($132,000 / (1 + 0.10)^5) -
$200,000 = $3,180

Expected NPV = (0.35 * -$24,769) + (0.35 * -$7,405) + (0.30 * $3,180) = -$10,248

Standard deviation is a measure of the spread of the NPV values in the different scenarios. It can be
calculated as:

Standard deviation = √{Σ(NPV - expected NPV)^2 * probability}

Standard deviation = √{(($24,769 + $10,248)^2 * 0.35) + (($7,405 + $10,248)^2 * 0.35) + (($3,180 -

$10,248)^2 * 0.30)} Standard deviation = $16,101

Coefficient of variation (CV) is a measure of the relative variability of the NPV values and is calculated as
the standard deviation divided by the expected NPV:

CV = Standard deviation / Expected NPV CV = $16,101 / $-10,248 = 1.57

A CV value of 1.57 suggests that the project NPV has high relative variability, which may indicate a
higher level of risk. Based on this information, it is difficult to make a clear recommendation whether to
accept or reject the project. The decision will depend on the organization's risk tolerance and their
overall portfolio of investments.
11.13

The Everly Equipment Company’s flange-lipping machine was purchased 5 years ago for $55,000. It had
an expected life of 10 years when it was bought and its remaining depreciation is $5,500 per year for
each year of its remaining life. As the older flange-lippers are robust and useful machines, it can be sold
for $20,000 at the end of its useful life. A new high-efficiency, digital-controlled flange-lipper can be
purchased for $120,000, including installation costs. During its 5-year life, it will reduce cash operating
expenses by $30,000 per year, although it will not affect sales. At the end of its useful life, the high
efficiency machine is estimated to be worthless. MACRS depreciation will be used, and the machine will
be depreciated over its 3-year class life rather than its 5-year economic life, so the applicable
depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%. The old machine can be sold today for
$35,000. The firm’s tax rate is 35%, and the appropriate WACC is 16%.

a. If the new flange-lipper is purchased, what is the amount of the initial cash flow at Year 0?

b. What are the incremental net cash flows that will occur at the end of Years 1 through 5?

c. What is the NPV of this project? Should Everly replace the flange-lipper?

Solution:

a. The amount of the initial cash flow at Year 0 is calculated as follows:

Cost of new machine: $120,000

Sale of old machine: $35,000

Initial cash flow: $120,000 - $35,000 = $85,000

b. Incremental net cash flows at the end of Years 1 through 5 can be calculated as follows: Year 1:

Depreciation of new machine: $120,000 * 33.33% = $39,996

Operating expenses savings: $30,000

Tax savings: $39,996 * 35% = $13,999

Incremental net cash flow: $30,000 - $13,999 - $39,996 = $-23,995

Year 2:

Depreciation of new machine: $120,000 * 44.45% = $53,340

Operating expenses savings: $30,000

Tax savings: $53,340 * 35% = $18,684

Incremental net cash flow: $30,000 - $18,684 - $53,340 = $-35,344

Year 3:

Depreciation of new machine: $120,000 * 14.81% = $17,776

Operating expenses savings: $30,000

Tax savings: $17,776 * 35% = $6,218

Incremental net cash flow: $30,000 - $6,218 - $17,776 = $6,006

Year 4:

Depreciation of new machine: $120,000 * 7.41% = $8,888

Operating expenses savings: $30,000

Tax savings: $8,888 * 35% = $3,109

Incremental net cash flow: $30,000 - $3,109 - $8,888 = $18,013

Year 5:

Depreciation of new machine: $120,000 * 7.41% = $8,888

Operating expenses savings: $30,000

Tax savings: $8,888 * 35% = $3,109

Incremental net cash flow: $30,000 - $3,109 - $8,888 = $18,013

c. The NPV can be calculated using the formula: NPV = ∑ [(CF / (1 + r)^t] - I, where CF is the incremental
net cash flow, r is the discount rate (WACC), t is the year, and I is the initial investment.

NPV = [($-23,995 / (1 + 0.16)^1) + ($-35,344 / (1 + 0.16)^2) + ($6,006 / (1 + 0.16)^3) + ($18,013 / (1 +

0.16)^4) + ($18,013 / (1 + 0.16)^5)] - $85,000 = $-14,290.39

Since the NPV is negative, the Everly Equipment Company should not replace the flange-lipper.
11.14

DeYoung Entertainment Enterprises is considering replacing the latex molding machine it uses to
fabricate rubber chickens with a newer, more efficient model. The old machine has a book value of
$450,000 and a remaining useful life of 5 years. The current machine would be worn out and worthless
in 5 years, but DeYoung can sell it now to a Halloween mask manufacturer for $135,000. The old
machine is being depreciated by $90,000 per year for each year of its remaining life. The new machine
has a purchase price of $775,000, an estimated useful life and MACRS class life of 5 years, and an
estimated salvage value of $105,000. The applicable depreciation rates are 20.00%, 32.00%, 19.20%,
11.52%, 11.52%, and 5.76%. Being highly efficient, it is expected to economize on electric power usage,
labor, and repair costs, and, most importantly, to reduce the number of defective chickens. In total, an
annual savings of $185,000 will be realized if the new machine is installed. The company’s marginal tax
rate is 35%, and it has a 12% WACC.

a. What is the initial net cash flow if the new machine is purchased and the old one is replaced?

b. Calculate the annual depreciation allowances for both machines, and compute the change in the
annual depreciation expense if the replacement is made.

c. What are the incremental net cash flows in Years 1 through 5?

d. Should the firm purchase the new machine? Support your answer. e. In general, how would each of
the following factors affect the investment decision, and how should each be treated? (1) The expected
life of the existing machine decreases. (2) The WACC is not constant but is increasing as DeYoung adds
more projects into its capital budget for the year.

Solution:

a. The initial net cash flow if the new machine is purchased and the old one is replaced can be calculated
as follows:

Purchase price of new machine: $775,000

Sale of old machine: $135,000

Depreciation of old machine ($90,000 * 5 years): $450,000

Initial net cash flow: $775,000 + $135,000 - $450,000 = $460,000

b. The annual depreciation allowances for both machines can be calculated as follows:

Depreciation of old machine: $90,000

Depreciation of new machine: $775,000 * 20.00% = $155,000

Change in annual depreciation expense: $155,000 - $90,000 = $65,000

c. The incremental net cash flows in Years 1 through 5 can be calculated as follows:

Incremental cash flow = Savings from new machine - Depreciation of new machine - Taxes (35%)
Year 1: $185,000 - $155,000 * 35% = $82,925

Year 2: $185,000 - $155,000 * 32% = $90,560

Year 3: $185,000 - $155,000 * 19.20% = $120,832

Year 4: $185,000 - $155,000 * 11.52% = $139,072

Year 5: $185,000 - $155,000 * 11.52% = $139,072

d. Based on the calculations above, the firm should purchase the new machine. The incremental net
cash flows in Years 1 through 5 are positive and increase over time, which means the investment is
expected to be profitable in the long run.

e. (1) The expected life of the existing machine decreases - this would decrease the value of the old
machine and the amount that can be received from selling it. This would increase the initial outflow and
make the investment less attractive.

(2) The WACC is not constant but is increasing as DeYoung adds more projects into its capital budget for
the year - this would increase the cost of capital, making the investment less attractive. The incremental
net cash flows would decrease, and the required rate of return would increase, which would affect the
investment decision.