The Frooty Company is a family-owned business that produces fruit jam. The company has a grinding machine that has been in use for 3 years. On January 1, 2014, Frooty is considering the purchase of a new grinding machine. Frooty has two options: (1) continue using the old machine or (2) sell the old machine and purchase a new machine. The seller of the new machine isnt offering a trade-in. The following information has been obtained:

Frooty is subject to a 34% income tax rate. Assume that any gain or loss on the sale of machines is treated as an ordinary tax item and will affect the taxes paid by Frooty in the year in which it occurs. Frootys after-tax required rate of return is 12%. Assume all cash flows occur at year-end except for initial investment amounts.

Required:

Hint: The analysis period begins on 1/1/2014 this is the beginning of the 4^th year of the old machines useful life. The company doesnt have to pay for the old machine again.

1. A manager at Frooty asks you whether its financially better to keep the old machine for five more years or to buy the new machine now. To help in your analysis, calculate the following:
   1. One-time after-tax cash effect of disposing of the old machine on January 1, 2014
   2. The after-tax cash operating costs of keeping the old machine, of buying the new machine, and the difference between the two values (variable and fixed costs separately).
   3. The total difference between the depreciation tax shield (DTS) resulting from keeping the old machine and buying the new machine.
   4. Difference in after-tax cash flow from the terminal disposal of new machine and old machine
2. Use the net present value method to determine whether Frooty should use the old machine or acquire the new machine. Calculate the NPV of each option the way it was done in class. Check the NPV calculations using the NPV function in Excel.
3. How much more or less would the recurring after-tax cash operating savings of the new machine need to be for Frooty to be indifferent about whether to keep the old machine or buy the new machine? Assume that all other data about the investment remains the same.

Check Figures (Please note that check figures may not be final answers. Read the question carefully):

1a. Net undiscounted CF from selling old machine 1/1/2014 = $63,997

1b. Old machine, after tax operating costs =$94,875; New machine after tax operating costs =$75,405

1c. Old machine, total amount of DTS $22,302; New machine, total amount of DTS $57,158

1d. Net cash from selling old equipment in 2018 =$7,920; Net cash from selling the new machine in 2018 = $21,962

2. NPV of keeping the old machine =$(320,768); NPV of buying the new machine = $(338,490)

3. Annual reduction in operating costs = $4,916

Old Machine New Machine Initial purchase cost of machines $ 150,000 $ 190,000 Useful life from acquisition date (years) 8 5 Expected annual cash operating costs Variable cost per can of jam $ 0.25 $ 0.19 Total fixed costs $ 25,000 $ 24,000 Depreciation method for tax purposes MACRS, 7 year asset MACRS, 5 year asset Estimated disposal value of machines January 1, 2014 $ 68,000 $ 190,000 December 31, 2018 $ 12,000 $ 22,000 Expected cans of jam produced and sold each year 475,000 475,000