QUESTION TREE

The Arena Bottling Company (ABC) is contemplating the replacement of one of its bottling machines with a newer, more efficient one. The old machine has a book value of $600,000 and a remaining useful life of five years. The company does not expect to realise any return from scrapping the old machine in five years, but it can be sold today to another company in the industry for $265,000. The old machine is being depreciated toward a zero-salvage value, or by $120,000 per year, by the straight-line method.

The new machine has a purchase price of $1,175,000, an estimated useful life and the assets effective life of five years depreciated under straight-line method, and an estimated market value of $0 at the end of five years. The machine is expected to economise on electric power usage, labour and repair costs, which will save Arena $230,000 each year. In addition, the new machine is expected to reduce the number of defective bottles, which will save an additional $25,000 annually.

The companys marginal tax rate is 30 per cent and it has a 6 per cent required rate of return.

REQUIRED:

1. 1. What initial investment outlay is required for the new machine?
   2. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made.
   3. What are the incremental operating cash flows in Years 1 through 5?
   4. Should the company purchase the new machine? Support your answer.
   5. In general, how would each of the following factors affect the investment decision, and how should each be treated?
2. The expected life of the existing machine decreases.
3. The required rate of return is not constant but is increasing as Boyd adds more projects into its capital budget for the year.

(Refer to Appendix 6 for the Present Value Tables)

(3 + 3 + 2.5 + 4.5+ 3 (2+1) = 16 marks)