Flax Industries is considering replacing a 4-year old FlaxXer Machine with a newer and more efficient FlaxXer Machine.

Flax Industries has a WACC = 9% and a Tax Rate = 30%.

The Old FlaxXer was originally purchased for $1,000,000 four years ago and is being depreciated using 5-year MACR schedule (thus, there are 2 years left of depreciation). If replaced, it could be sold for $185,000. The Old FlaxXer still has another 5 years left in its remaining economic life and could be sold as scrap metal for $10,000 at the end of the 5 years.

The New FlaxXer purchase price is $625,000 and it also has a useful economic life of 5 years. It will also be depreciated using 5-year MACR schedule. The New FlaxXer will generate $125,000 in new savings (earnings) before depreciation and taxes if purchased. At the end of 5-years the New FlaxXer will be sold for an estimated $60,000.

If the New FlaxXer is purchased, then Net Working Capital will increase by $10,000 due to the necessity of holding more Inventory parts. However, Net Working Capital will decrease by $10,000 when the project is terminated at the end of the five year life of the project.

Find the Incremental Depreciation (the difference between the depreciation of the New and Old FlaxXer) for each year over the 5-year life of the project.

What is the Initial Cash outlay (Initial Investment) if the New FlaxXer is purchased to replace the Old FlaxXer?

Find the Incremental After-tax Operating Cash Flows for Years 1 – 5.

Find the Terminal Year cash flow (i.e., the cash flow associated with ending the project at the end of Year 5).

Calculate the NPV and IRR for purchasing the New FlaxXer. [Don’t forget to include Terminal Year CF as part of cash flows received in Year 5!]

Based on your answer in (6) above, explain why or why not the firm should buy the New FlaxXer.

In your answer provide an interpretation of the NPV and IRR.

MACRS 5-year Class Depreciation Schedule:

Class 1 2 3 4 5 6

5-year 20% 32% 19% 12% 11% 6%