Question
You are a financial analyst at the Humongous Project Company (HPC). Four years ago, HPC purchased a machine at an installed cost of $70,000; the
You are a financial analyst at the Humongous Project Company (HPC). Four years ago, HPC purchased a machine at an installed cost of $70,000; the machine is being depreciated using MACRS with a 5-year recovery period. The machine has six years of useful life remaining and could be sold today for $403,000 after removal and cleanup costs.
A new, more efficient machine can be purchased for $280,000. The new machine would cost $10,000 to install and would have a useful life of 6 years; it would be depreciated using a 5-year MACRS depreciation recovery schedule. At the end of the six years, it would have an estimated salvage value of $60,000.
Because of the increased output of the new machine, the firm's sales would rise, with a corresponding increase in accounts receivable of $40,000, an increase in inventories of $25,000, and an increase in accounts payable of $35,000.
The following chart shows the expected revenues and operating costs for the new and old machine for each year.
New Machine
Old Machine
Year
Revenue
Operating Costs
Revenue
Operating Costs
1
$265,000
$105,000
$140,000
61,000
2
$275,000
$115,000
$144,000
62,000
3
$285,000
$125,000
$148,000
$63,000
4
$295,000
$135,000
$150,000
$64,000
5
$280,000
$140,000
$146,000
$62,000
6
$275,000
$145,000
$143,000
$60,000
HPC's applicable tax rate is 21%.HPC's weighted-average-cost-of-capital is 14%. HPC uses a 4-year payback period rule, along with NPV, PI, and IRR.
The MACRS 5-year property depreciation schedules are as follows:
Year
Recovery Percentage
1
20%
2
32%
3
19%
4
12%
5
12%
6
5%
a.Determine the initial investment associated with the proposed investment decision.
b.Calculate the incremental operating cash flows for years 1 through 6 associated with the proposed replacement.
c.Calculate the terminal cash flow associated with the proposed replacement decision.
d.Show the relevant cash flows on a timeline.
e.Compute the NPV, IRR, Profitability Index, and payback period for this project. Should HPC accept this replacement decision? Why or why not?
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