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Durst Equipment Company

The Durst Equipment Company purchased a machine 5 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 if $10,000 at the end of the 10 years. It is being depreciated by the straight line method toward a salvage value of $10,000, or by $9,000 per year.
A new machine can be purchased for $150,000 including installation costs. Over its 5-year life, it will reduce cash operating 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. MACRS depreciation will be used, and it will be depreciated over a 3-year recovery period rather than its 5-year economic life.

The old machine can be sold today for $65,000. The firmâ??s tax rate is 34%. This appropriate discount rate is $15%.
a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0?
b.What incremental operating cash flows will occur at the end of Year 1 through 5 as a result of replacing the old machine?
c. What incremental nonoperating cash flow will occur at the end of Year 5 if the new machine is purchased?
d. What is the NPV of this project? Should the firm replace the old machine?

Solution Preview

( Replacement Analysis ) The Durst Equipment Company purchased a machine 5 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 if $10,000 at the end of the 10 years. It is being depreciated by the straight line method toward a salvage value of $10,000, or by $9,000 per year.

A new machine can be purchased for $150,000 including installation costs. Over its 5-year life, it will reduce cash operating 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. MACRS depreciation will be used, and it will be depreciated over a 3-year recovery period rather than its 5-year economic life.

The old machine can be sold today for $65,000. The firm's tax rate is 34%. This appropriate discount rate is $15%.

We have to first determine the depreciation and remaining book value of the old machine. We know the old machine (with an expected life of 10 years) was bought 5 years ago, so this machine has a remaining life of 5 years. At the end of its life, the machine will have a salvage value of $10,000.
Since the machine is 5 years old, that means the firm has written off a total of $45,000 (9,000 x 5 years) in depreciation. Therefore, the machine's remaining ...

Solution Summary

This solution is comprised of a detailed explanation to answer what is the amount of the initial cash flow at Year 0.

$2.19