A firm is considering investing in a new machine with a price of $32 million to replace its existing machine. The current machine has a book value today of $16 million and a market value of $20 million. Either the current or new machine is needed for four years beyond which the project will be terminated. The most recent year sales were $25 million. If the firm continues with the existing equipment, sales are expected to grow annually at the rate of 5% and the operating costs (excluding depreciation) are projected at 55% of sales. On the other hand, if the new machine is purchased, sales are expected to grow at an annual rate of 7% and the operating costs (excluding depreciation) are projected at 50% of sales. While the existing machine will have no salvage value at the end of four years, the new machine can be sold for $16 million. The net working capital required is expected to be 5% of next year sales, regardless of whether the new machine is purchased, or the firm continues with the existing machine. The tax rate is 34% and the cost of capital is 10%. The existing machine is being depreciated on a straight-line basis over the next four years while the new machine will be depreciated based on the 5-year MACRS (20%, 32%, 19%, 12%, 11%, and 6%). Construct the capital budgeting model for this replacement project. What is the NPV and IRR of the decision to replace the existing machine? Should the existing machine be replaced?

New Equipment Depreciation Yr Depreciation Rate Ending BV Year Dep Amount 20% Existing Equipment Depreciation Ending Depreciation Book Rate Dep Amount Value 1 25% $ 4.00 $ 12.00 2 25% $ 4.00 $ 8.00 3 25% $ 4.00 $ 4.00 4 25% $ 4.00 $ $ 25.00 1 4 2 3 32 16 32% 19% 12% 11% $ 4 5 6 6% Assumptions Sales in Most Recent Year-Millions Equipment Life in years Cost of New Machine in Millions Selling Price New Machine at End of Project New Equipment Depreciation (20%, 32%, 19%, 12%, 11%, 6%) Annual Growth in Sales with New Machine Operating Costs/Sales with New Machine Tax Rate Cost of Capital Existing Machine Depreciation-Straight Line-4 Yrs Current Market Value of Existing Machine-Millions Current Book Value of Existing Machine Millions Annual Growth in Sales with Existing Machine Operating Costs/Sales- with Existing Machine Net Working Capital as % Next Year Sales 7% 50% 34% 10% New Equipment 0 1 2 3 4 $ 25.00 $ $ 20.00 16.00 5% 55% 5% Sales Operating costs Depreciation EBIT EBIT*(1-T) Operating Cash Flows 0 1 N 3 $ 25.00 Existing Equipment Sales Operating costs Depreciation EBIT EBIT*(1-T) Operating Cash Flows