Question

The Bigbee 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 years, 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 initial cash outlay is required for the new machine? 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 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 Bigbee adds more projects into its capital budget for the year.

Answer 1

The Bigbee Bottling Company's initial cash outlay for the new machine is $910,000. Annual depreciation is calculated according to MACRS for the new machine and straight-line for the old. The decision to purchase the new machine should be based on positive NPV using 12% WACC, considering tax effects, and factoring any incremental savings or costs.

Step-by-step explanation:

Bigbee Bottling Company Machine Replacement Analysis

The Bigbee Bottling Company is considering replacing an old bottling machine with a new, more efficient one. Below is the financial analysis for the replacement decision:

a. Initial Cash Outlay for the New Machine

The initial cash outlay required for the new machine is the purchase price minus the proceeds from selling the old machine. Therefore, the outlay is $1,175,000 - $265,000 = $910,000.

b. Annual Depreciation Allowances and Change in Depreciation Expense

The old machine's depreciation is $120,000 annually (straight-line method). For the new machine, using the Modified Accelerated Cost Recovery System (MACRS) over 5 years with depreciation rates of 20%, 32%, 19%, 12%, 11%, and 6%, the depreciation amount changes each year.

c. Incremental Cash Flows in Years 1 through 5

The incremental cash flows are calculated by considering the annual savings, the difference in depreciation, and the effect of the tax rate at 35%, along with the new machine's salvage value at the end of its life.

d. Purchase Decision

The firm should calculate the net present value (NPV) of the incremental cash flows using the 12% WACC and determine if it's positive to make the purchase decision.

e. Factors Affecting the Investment Decision

• If the WACC is increasing due to adding more projects, more careful analysis on the required return for the new project is needed.