Principles of Finance (FIN 3213)

Capital Budgeting - Replacement Project

Homework #24 (10 points) due 11:59 p.m., December 4, 2020

The Puebla Pottery Company produces high quality, terra cotta dinner ware. The company uses an automated process to prepare the clay for molding and firing. They are considering replacing one of the clay preparation machines.

The machine being considered for replacement was purchased 5 years ago. It has a depreciable base of $2600. The machine has an annual depreciation of $260 and has 5 years of life remaining. The old machine can be sold today for $1,000.

A replacement machine will cost $18,000 and have an estimated useful life of 5 years. It will need to be modified for Puebla's specific needs at a cost of $5,000. Installation is expected to cost $1,000. At the end of 5 years, Puebla Pottery expects to sell the replacement machine for $500. The machine has a MACRS 5-year recovery period.

The replacement machine is expected to produce more dinner ware and will increase sales by $15,000 per year. But, its more complex technology would require more maintenance and is expected to increase operating expenses (mainly labor) by $8,000 per year. The new machine would require that raw materials inventories be increased by $12,000, but accounts payable would simultaneously increase by $5,000.

The firm's marginal federal-plus-state tax rate is 40% and its cost of capital is 5%.

A. What is the initial cash flow?

B. What are the operating cash flows?

C. What is the terminal cash flow?

D. What is the project's net present value (NPV) and its internal rate of return (IRR)?

E. Should Puebla Pottery Company replace the old machine? Why or why not?