ZPM Corporation (ZPMC) is planning to purchase new equipment. If equipment is purchased, it will replace the old equipment purchased 10 years ago for $105,000, which is being depreciated on a straight-line basis to a zero salvage value (15-year depreciable life). The old equipment can be sold for $60,000. The price of new equipment will be $180,000; however, there are additional costs of $15,000 for installation and $5,000 for transportation. The new equipment will be depreciated using MACRS over its 5-year class life and it will be sold at its book value at the end of the fifth year. The firm expects to increase its revenues by $18,000 per year if the new equipment is purchased, but cash expenses will also increase by $2,500 per year. The new equipment will require an increase of $2,000 net in working capital. ZPMC's cost of capital is 10 percent and its tax rate is 35 percent. ZPMCs policy is to use two different capital budgeting techniques, IRR and NPV, to evaluate the projects.

• PleaseadviseZPMCifthecompanyshouldreplacetheoldequipmentbasedonZPMCpolicy,JustifyyouradviceforZPMCmanagement,andshowallyourcalculations.
• NOTE ( YOU WILL FIND AN EXAMPLE FOR THIS CASE IN THEFILE ATTACHED. THIS FILE HAS ALL FORMULA THAT YOU MAY NEED AND OTHER INFORMATION.

Mr.Gigi Buffon, head of the capital budgeting office at the Bambola Production Company (BPC), is assigned to evaluate a project that is currently considered by BPC. BPC purchased a doll-producing machine 4 years ago at a cost of $100,000. It had an expected life of 10 years at the time of purchase and an expected salvage value of $10,000 at the end of the 10 years. It is being depreciated using the straight-line method toward a salvage value of $10,000. A new and more cost efficient doll-producing machine can be purchased for $130,000, excluding total installation costs of $20,000. Over its 6-year life, it will reduce cash operation expenses by $50,000 per year. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worthless. Mr. Gigi Buffon has decided to use MRCRS deprecation and assumes that the machine falls into the MACRS 5-year class. The old machine can be sold today for $65,000. BPC's tax rate is 30 percent and its estimated WACC is 15 percent. 1) Calculate Net Investment at t0: a. Gain from disposing old machine: Dep. of old machine: 100,000 10,000 OldDep. $9,000 10 Book Value of the old machine (end of year 4) = 100,000 - 4(9,000) = $64,000 Gain form selling the old machine: 65,000 - 64,000 = $1,000 (subject to recapture at 30% tax rate) Tax effect = (1,000)(0.30) = $300 b) Net Investment (cash outlay at t0) Price of new machine (150,000) SV(old machine) price at which it was sold 65,000 Tax effect (300) Total cash outflow at t0 (85,300) 2) Calculation of Incremental Operating Cash Flows for Each Year: a) Calculate depreciation expenses of new machine, depreciation of the old machine and changes in depreciation (part of IOCF): Year Dep. Dep. Expen. in for new Expen. Old Mach. Depr. Machine b) Dep. Basis % 1 (5) 2(6) 3(7) 4(8) 5(9) 6(10) MACRS New 150,000 150,000 150,000 150,000 150,000 150,000 Mach. 30,000 48,000 28,500 18,000 16,500 9,000 9,000 9,000 9,000 9,000 9,000 9,000 21,000 39,000 19,500 9,000 7,500 0.00 20 32 19 12 11 6 Calculation of Incremental Operating Cash Flows: Let us consider the effect of this replacement on income statement and operation cash flow in the first year of replacement. Note that S new = Sold and the division saves $50,000 in operating expenses if new machine is employed (cost saving replacement) Oper.Inc. Dep. NIBT Taxes@30% NIAT Add Dep. IOCF Old M. 100,000 (9,000) 91,000 (27,300) 63,700 9,000 72,700 New M. 150,000 (30,000) 120,000 (36,000) 84,000 30,000 114,000 (difference) 50,000 (21,000) 29,000 (8,700) 20,300 21,000 41,300 Therefore, the IOCF in the first year is $41,300, which is the only OCF relevant to this replacement project. We need to do this procedure to calculate IOCFt for all t's where t = 1,2,3,4,5,6. However there the following formula makes this set of calculations easy: IOCFt = (S t - OC t) (1 - T) + Dep t (T) Where: S t = change in Sales as a result of replacement (new machine) OC = change in operating costs as a result of replacement (new machine) Dep = change in depreciation as a result of new machine T = is division's marginal tax rate Notes: OC is generally negative if firm's objective is to reduce operating costs by replacement. So OC= OC New - OC Old0 That is Sales increasing investment. Applying above formula to our division we have: IOCF1 = (0 - (- 50,000)(1 - 0.30) + +(21,000)(0.30) = 35,000 + 6,300 = 41,300 Similarly: IOCF2 = (0 - (- 50,000)(1 - 0.30) + +(39,000)(0.30) = 35,000 + 11,700 = 46,700 IOCF3 = (0 - (- 50,000)(1 - 0.30) + +(19,500)(0.30) = 35,000 + 5,850 = 40,850 IOCF4 = (0 - (- 50,000)(1 - 0.30) + +(9,000)(0.30) = 35,000 + 2,700 = 37,700 IOCF5 = (0 - (- 50,000)(1 - 0.30) + +(7,500)(0.30) = 35,000 + 2,250 = 37,250 IOCF6 = (0 - (- 50,000)(1 - 0.30) + +(0.00)(0.30) = 35,000 = 35,000 3) Incorporating Opportunity costs, if any. In this case we have: SVNew = $0 SVOld = $10,000 So as a result of replacement, the firm will lose $10,000 (salvage value of the old machine) in the year 6. This is the opportunity cost of having sold the old machine in year 0. Since opportunity costs are relevant, hence the cash flow in year 6 will be: IOCF Non operating CF Total CF $35,000 (10,000) 25,000 Note that we will not receive $10,000 by choosing new machine. 4) Project Evaluation. We now use capital budgeting techniques to evaluate the replacement project. 41,300 46,700 40,850 37,700 37,250 25,000 (1.15)1 (1.15) 2 (1.15) 3 (1.15) 4 (1.15) 5 (1.15) 6 85,300 148,968 0 NPV 85,300 Therefore, Bambola Production Company should replace the old machine. We could also calculate IRR, PBP, PI or MIRR for this project. For example IRR = 42%. Since COC of the firm is 15%, therefore the project is accepted. Proof of the formula: S - C - Dep = Net Operating Income (S - C - Dep)(1-T) = OIAT (S - C - Dep)(1-T) +Dep = operating cash flow Recognizing only incremental items yields: OCF t =( S - OC - Dep)(1-T) + Dep = =( S - OC )(1-T) - Dep + (Dep)(T) + Dep = ( S - OC )(1-T) + (Dep)(T) A Note: This way treatment of net working capital (NWC) is a simplification. In reality, NWC cannot be treated as an investment made when the project is adopted and recovered when the project ceases to exist. NWC can change from period to period. MACRS DEPRECIATION BY CLASS OF PROPERTY Year 1 2 3 4 5 3-year 33.00 45.00 15.00 7.00 5-year 20.00 32.00 19.0 12.00 11.00 7-year 14.00 25.00 17.00 13.00 9.00 10-year 10.00 18.00 14.00 12.00 9.00 15-year 5.00 9.50 8.55 7.70 6.93 20-year 3.75 7.22 6.68 6.18 5.71 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 6.00 9.00 9.00 4.00 7.00 7.00 7.00 7.00 6.00 3.00 6.23 5.90* 5.90 5.91 5.90 5.90 5.90 5.91 5.90 5.91 2.95 5.29 4.89 4.52 4.46 4.46 4.45 4.46 4.46 4.46 4.46 4.46 4.46 4.46 4.46 4.46 2.23