The Balboa Bottling Company is contemplating the replacement of one of
its bottling machines with a newer and more efficient one. The old
machine has a book value of $600,000 and a remaining useful life of 5
years. The firm does not expect to realize any return from scrapping the
old machine in 5 year, but it can sell it now to another firm in the
industry for $265,000. The old machine is being depreciated by $120,000
per year, using the straight line method.
The new machine has a purchase price of $1,175,000, an estimated useful
life and MACRS class life of 5 years, and an estimated salvage value of
$145,000. The applicable depreciation rates are 20%, 32%, 19%, 12%, 11%
and 6%. It is expected to economize on electric power usage, labor, and
repair costs, as well as to reduce the number of defective bottles. In
total, an annual savings of $255,000 will be realized if the new machine
is installed. The company's marginal tax rate is 35%, and it has a 12%
WACC.
a) What is the initial net cash flow if the new machine is purchased and the old one is replaced?
b) Calculate the annual depreciation allowances for both machines, and
compute the change in the annual depreciation expense if the replacement
is made.
c) What are the incremental net cash flows in Years 1 through 5?
d) Should the firm purchase the new machine? Support your answer.
e) In general, how would each of the following factors affect the investment decision, and how should each be treated?
(1) The expected life of the existing machine decreases.
(2) The WACC is not constant but is increasing as Balboa adds more projects into its
capital budget for the year.
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