Analyzing cash flows from alternatives. Texico Steelworks is considering purchasing a new machine for $1 million at the end of Year 0 to be put into operation at the beginning of Year 1. The new machine will save $250,000. before taxes, per year from the cash outflows generated by using the old machine. For tax purposes. Texico Steelworks will depreciate the new machine in the following amounts: $100,000 in Year 1. $300,000 in Year 2. and $200,000 per year thereafter until fully depreciated or sold. The new machine will have no salvage value at the end of Year 5. Texico Steelworks expects the new machine to have a market value of $400,000 at the end of 3 years.

If Texico Steelworks acquires the new machine at the end of Year 0. it can sell the old one for $200,000 at that time. The old machine has a tax basis of $300,000 at the end of Year 0. If Texico Steelworks keeps the old machine, the company w ill depreciate itf or tax purposes in the amount of $100,000 per year for 3 years, w hen it will have no market \ a lue.

Texico Steelworks pays taxes at the rate of 40 percent of taxable income and uses a cost of capital of 12 percent in evaluating this possible acquisition. Texico Steelworks has sufficient otherwise-taxable income in Year 0 to save income taxes for each dollar of loss it may incur if it sells the old machine at the end of Year 0.

a. Compute the net present value of cash flows from each of the alternatives facing Texico Steelworks.

b. Make a recommendation to Texico Steelworks.

c. Assume that the cash flows described in the problem for Years 2 through 5 are real, not nominal, amounts, but the 12-percent cost of capital includes an allowance for inflation of 6 percent. Describe how this will affect your analysis.

You need not perform new computations.