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# Appraising replacement decision by NPV

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PROBLEM ONE
Refresh Bottling Co. (RBC) is considering replacing one of its many bottling machines which was purchased five years ago for \$52,000 with an estimated remaining useful life of five years and a salvage value of \$2,200. RBC realized that there is a new bottling machine that can replace the old one which could be sold today for \$4,500. The retail price of new bottling machine is \$75,500 in Canada, but RBC can buy the same machine for a 15% discount from a vendor in the United States. The new bottling machine will increase sales by \$10,200 each year. The new machine will also economize on annual operating expense, which was \$8,600 for the old machine, but would be \$7,500 per year for the new machine. The old machine also requires an operator whose annual salary is \$16,500 per year. Although the new machine will not require an operator each year, there will be a \$3,500 installation cost after the purchase. The new bottling machine could be sold for \$7,400 at the end of seven years. RBC's working capital requirement is expected to decrease by \$8,200 at the end of the second year of operations, but this will revert to its original level once the project is completed in seven years. The applicable discount rate is 14%, the CCA rate is 20% and the tax rate is 35%. Should RBC purchase the new bottling machine?

PROBLEM TWO
Filkins Fabric Company (FFC) is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: Machine 190-5, which has a cost of \$190,000, a 5-year expected life with a salvage value of \$1,900. Machine 360-11 has a cost of \$360,000, an 11-year life with a salvage value of 3,600. The operating cost each year for Machine 190-5 is \$92,450 and for Machine 360-11 is \$110,200 per year. Knitting machine prices are not expected to rise, because inflation will be offset by cheaper components (microprocessors) used in the machines. Assume that Filkins has a discount rate of 14%, the capital cost allowance (CCA) rate is 20% and tax rate is 35%. Should the company choose Machine 190-5 or Machine 360-11 to replace the old machine?

Meaning of CCA:
CCA is depreciation for tax purposes in Canada not necessarily the same as depreciation under GAAP. CCA for each year is computed by multiplying the asset's book value for tax purposes, called undepreciated capital cost (UCC), by the appropriate rate.

#### Solution Preview

Press 1 Projected Cash Flow
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year6 Year7
Revenues 0 10200 10200 10200 10200 10200 10200 10200
Installation Cost -63175 0 0 0 0 0
Savings 17600 17600 17600 17600 17600 17600 17600

Total Savings+Revenues 27800 27800 27800 27800 27800 27800 27800
Equipment depreciation (schedule) 12055 9644 7715.2 6172.16 4937.728 3950.1824 3160.14592
Before tax income 15745 18156 20084.8 21627.84 22862.272 23849.8176 24639.85408
Taxes 5510.75 6354.6 7029.68 7569.744 8001.7952 8347.43616 8623.948928
Net Income 10234.25 11801.4 13055.12 14058.096 14860.4768 15502.38144 16015.90515
Plus Depreciation of Equipment 12055 9644 7715.2 6172.16 4937.728 3950.1824 3160.14592
Change in Net Working Capital 8200 8200
Salvage Value 7400
Net Operating Cash ...

#### Solution Summary

Solution contains step by step instruction in the Excel file for taking the replacement decision by using NPV technique.

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