Holliday Manufacturing is considering the replacement of an existing machine. The new machine costs $1.2 million and requires installation costs of $150,000. The existing machine can be sold currently for $185,000 before taxes. It is two years old, cost $800,000 new, and has a $384,000 book value and a remaining useful life of five years. It was being depreciated under MACRS, using a five year recovery period, and therefore has the final four years of depreciation remaining. If it is held for five more years, the machines market value at the end of year 5 will be $0. Over its five year life, the new machine should reduce operating costs by $350,000 per year. The new machine will be depreciated under MACRS, using a five year recovery period. The new machine can be sold for $200,000 net of removal and cleanup costs at the end of five years. Increased investment in net working capital of $25,000 will be needed to support operations if the new machine is acquired. Assume that the firm has adequate operating income against which to deduct any loss experienced on the sale of the existing machine. Hollidays total capital has a market value of $10 million, with $3 million in debt and $5 million in common equity. Hollidays has an equity beta of 1.2, a cost of debt of 8%, and a cost of preferred stock of 12.8%. The annual market risk premium is 5% and the 5-year Treasury note has a yield of 4%. Questions:

1. Assuming a tax rate of 40%, what is the WACC of the firm?

2. Develop the net cash flows needed to analyze the proposed replacement project.

3. Determine the net present value (NPV) of the proposal.

4. Determine the internal rate of return (IRR) of the proposal.

5. Make a recommendation to accept or reject the replacement proposal, and justify your answer.

6. What is the highest cost of capital that the firm could have and still accept the proposal? Explain.