Question

A small factory is considering replacing its existing coining press with a newer, more efficient one. The existing press was purchased three years ago at a cost of $200000, and it is being depreciated according to a 7-year MACRS depreciation schedule. The factoryâs CFO estimates that the existing press has 6 years of useful life remaining. The purchase price for the new press is $280000. The installation of the new press would cost an additional $20000, and this installation cost would be added to the depreciable base. The new press (if purchased) would be depreciated using the 7-year MACRS depreciation schedule although, as noted below, it would be retired/sold after 6 years. Interest expenses associated with the purchase of the new press are estimated to be roughly $4000 per year for the next 6 years.

The appeal of the new press is that it is estimated to produce a pre-tax operating cost savings of $81000 per year for the next 6 years. Also, if the new press is purchased, the old press can be sold for $30000 today. The CFO believes that the new press would be sold for $45000 at the end of its 6-year useful life. Assume that NWC would not be affected. The company has an average tax rate of 29% and a marginal tax rate of 34%. The cost of capital (i.e., the discount rate) for this project is 8.5%.

Required:
Develop the incremental cash flows for this replacement decision and use them to calculate NPV and IRR. Next, make a conclusion about whether or not the existing coining press should be replaced at this time.

Answer 1

1. Incremental Cash Flows:

Cash Flows Total PV of annual

Cash Flows

After-tax operating savings $57,510 $261,877

Sale proceeds from old press 30,000 30,000

Sale proceeds from new press 45,000 27,583

Total incremental cash inflows $132,510 $319,460

Cost of new press $280,000 $280,000

Installation cost of new press 20,000 20,000

Interest expense (associated) 4,000 18,214

Total incremental cash outflows $340,000 $318,214

2. NPV $1,246 ($319,460 -$318,214)

IRR = the cost of capital that will cause the NPV to be zero. Since it is $1,246, to find the rate, that makes it zero, we do the following calculations:

$1,246/$318,214 * 100 = 0.4%

Cost of capital = 8.5%

3. IRR = 8.5 - 0.4 = 8.1%

4. Conclusion: The existing press should be replaced at this time.

Step-by-step explanation:

a) Data and Calculations:

Cost of old press = $200,000

Estimated useful life remaining = 6 years

Cost of new press = $280,000

Installation cost = $20,000

Total cost of new press $300,000

Interest expenses per year for the new press = $4,000

Cost Savings from new press:

Pre-tax operating cost savings = $81,000 per year

After-tax savings = $57,510 ($81,000 * (1 - 29%))

Sales proceeds from old press = $30,000 today

Sale proceeds from new press = $45,000 (at the end of its 6-year life)

Average tax rate = 29%

Marginal tax rate = 34%

Cost of capital = 8.5%