example #5

For this example, calculate (1) the initial cash flow, (2) the operating cash flows, and (3) the terminal cash flow. Using the cost of capital (WACC) of 15%, calculate the project's NPV and IRR. Use the NPV and IRR to make a recommendation of whether the machine should be replaced. Be sure to be specific about why you make your recommendation.

Example #5 Replacement Project Analysis The Erickson Toy Corporation currently uses an injection molding machine that was purchased 2 years ago. It has a depreciable base of $2600. The machine is being depreciated on a straight-line basis toward a $500 salvage value, and it has 6 years of life remaining. This results in annual depreciation of $262.50. The old machine can be sold today for $2,000. The firm is offered a replacement machine that has a cost of $8,000 and an estimated useful life of 6 years. After 6 years, Erickson expects to sell the replacement machine for $800. The machine has a MACRS 5-year recovery period. The replacement machine would permit an output expansion, so sales would rise by $1,000 per year. Even so, the new machine's much greater efficiency would still cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500 . MACRS Depreciation Schedule Ownership Class of investment Year 3-year 5-year 7-year 10-year 1 33% 20% 14% 10% 2 2 45 32 25 18 3 15 19 17 14 4 7 12 13 12 5 11 9 9 6 6 9 7 7 9 7 8 4 7 9 7 10 6 11 3 Example #5 Replacement Project Analysis The Erickson Toy Corporation currently uses an injection molding machine that was purchased 2 years ago. It has a depreciable base of $2600. The machine is being depreciated on a straight-line basis toward a $500 salvage value, and it has 6 years of life remaining. This results in annual depreciation of $262.50. The old machine can be sold today for $2,000. The firm is offered a replacement machine that has a cost of $8,000 and an estimated useful life of 6 years. After 6 years, Erickson expects to sell the replacement machine for $800. The machine has a MACRS 5-year recovery period. The replacement machine would permit an output expansion, so sales would rise by $1,000 per year. Even so, the new machine's much greater efficiency would still cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500 . MACRS Depreciation Schedule Ownership Class of investment Year 3-year 5-year 7-year 10-year 1 33% 20% 14% 10% 2 2 45 32 25 18 3 15 19 17 14 4 7 12 13 12 5 11 9 9 6 6 9 7 7 9 7 8 4 7 9 7 10 6 11 3