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Homework answers / question archive / Muthusamy Curry Mills (MCM) is considering the purchase of a new milling equipment to replace an existing one that has a book value of $3,000 and can be sold for $1,500
Muthusamy Curry Mills (MCM) is considering the purchase of a new milling equipment to replace an existing one that has a book value of $3,000 and can be sold for $1,500. The old machine is being depreciated on a straight-line basis and its estimated salvage value 3 years from now is zero. The new machine will reduce costs (before taxes) by $7,000 per year. It has a 3-year life; with an installed cost of $14,000; and it can be sold for an expected $2,000 at the end of the third year. The new machine would be depreciated over its 3-year life using the MACRS method. The applicable depreciation rates are as follows:
Year 1: 33%
Year 2: 45%
Year 3: 15%
Year 4: 7%
Assume a 40% tax rate and a cost of capital of 16%.
a. What is the initial investment associated with the replacement of the old milling equipment by the new one ?
b. How much is the incremental operating cash flows associated with the proposed replacement in Year 1,2,3
c. How much is the terminal cash flow ?
d. How much is the NPV and IRR of the replacement project ?
f. Should MCM replace the old milling equipment with the new one?
Part (a)
Existing machine has a book value of $3,000 and can be sold for $1,500.
Loss on sale, L = Book value - sale value = 3,000 - 1,500 = $ 1,500
Tax rate = T = 40%
Tax credit = L x T = 1,500 x 40% = $ 600
Hence, post tax sale value = Sale value + tax credit = 1,500 + 600 = $ 2,100
Hence, the initial investment associated with the replacement of the old milling equipment by the new one = Cost of new machine - post tax sale value of old machine = 14,000 - 2,100 = $ 11,900
Part (b)
Please see the table below. All financials are in $. Please see the second column to understand the mathematics. The last row colored in yellow contains your answer.
| Year, n | Linkage | 0 | 1 | 2 | 3 |
| Installed cost | A | 14,000.00 | |||
| Depreciation rate | b | 33% | 45% | 15% | |
| Cost saving | C | 7,000.00 | 7,000.00 | 7,000.00 | |
| [-] Depreciation | D = A x b | 4,620.00 | 6,300.00 | 2,100.00 | |
| EBIT | E = C - D | 2,380.00 | 700.00 | 4,900.00 | |
| [-] Taxes | F = 40% x E | 952.00 | 280.00 | 1,960.00 | |
| NOPAT | G = E - F | 1,428.00 | 420.00 | 2,940.00 | |
| Incremental Operating cash flows | G + D | 6,048.00 | 6,720.00 | 5,040.00 |
Part (c)
Remaining book value at the end of year 3 = Undepreciated value = Installed cost x depreciation rate for year 4 = 14,000 x 7% = $ 980
Sale value = $ 2,000
Gain on sale = 2,000 - 980 = 1,020
Tax on gain = 40% x 1,020 = 408
Hence, post tax sale value of new machine = 2,000 - 408 = $ 1,592
Hence, the terminal cash flow = post tax sale value of new machine - post tax potential sale value of old machine = 1,592 - 0 = 1,592
Part (d)
Please see the table below. All financials are in $. Please see the second column to understand the mathematics. The last row colored in yellow contains your answer. Adjacent cell in blue shows the excel formula used to get the answer.
Part (e)
Yes, MCM replace the old milling equipment with the new one since
