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Machine Replacement and Investment Decisions

1) Terminal Cash Flow - Replacement decision
Russell Industries is considering replacing a fully depreciated machine having a remaining useful life of 10 years, with a newer more sophisticated machine. The new machine will cost $200,000 and will require $30,000 in installation costs. It will be depreciated under MACRS using a 5-year recovery period.
A $25,000 increase in net working capital will be required to support the new machine. The firm plans to evaluate the potential replacement over a 4-year period. They estimate that the old machine could be sold at the end of 4 years to net $15,000 before taxes. Calculate the terminal cash flow at the end of year 4 that is relevant to the proposed purchase of the new machine. The firm is subject to a 40 percent tax rate on both ordinary and capital gains income.

2) Making Norwich Tool's Lathe Investment Decision
Norwich Tool, a large machine shop, is considering replacing one of its lathes with either of two new lathes - lathe A or lathe B. Lathe A is a highly automated , computer-controlled lathe; lathe B is a less expensive lathe that uses standard technology. To analyze these alternatives, Mario Jackson, a financial analyst, prepared estimates of the initial investment and incremental (relevant) cash inflows associated with each lathe. These are shown in the following table.

Lathe A Lathe B
Initial
Investment $660,000 $360,000
Year (t)
1 $128,000 $88,000
2 182,000 120,000
3 166,000 96,000
4 168,000 86,000
5 450,000 207,000

Note that Mario plans to analyze both lathes over a 5-year period. At the end of that time, the lathes would be sold, thus accounting for the large fifth-year cash inflows.
One of Mario's major dilemmas centered on the risk of the two lathes. He feels that although the two lathes have similar risk, lathe A has a much higher chance of breakdown and repair due to its sophisticated and not fully proven solid-state electronic technology. Because he is unable to effectively quantify this possibility, Mario decides to apply the firm's 13 percent cost of capital when analyzing the lathes. Norwich Tool requires all projects to have a maximum payback period of 4.0 years.
a. Use the payback period to assess the acceptability and relative ranking of each lathe.

b. Assuming equal risk, use the following sophisticated capital budgeting techniques
1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)

c. Summarize the preferences indicated by the techniques used in a and b, and indicate which lathe you recommend, if either, if the firm has (1) unlimited funds (2) capital rationing.

d. Repeat part b assuming that Mario decides that, due to its greater risk, lathe A's cash inflows should be evaluated by using a 15 percent cost of capital.
e. What effect, if any, does recognition of lathe A's greater risk in d have on your recommendation in c?

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3. Terminal Cash Flow - Replacement decision
Russell Industries is considering replacing a fully depreciated machine having a remaining useful life of 10 years, with a newer more sophisticated machine. The new machine will cost $200,000 and will require $30,000 in installation costs. It will be depreciated under MACRS using a 5-year recovery period.

Rounded Depreciation Percentages by Recovery Year using MACRS for first four Property Classes.

Percentages by recovery year
Recovery Year 3 Years 5 Years 7 Years 10 Years
1 33% 20% 14% 10%
2 45% 32% 25% 18%
3 15% 19% 18% 14%
4 7% 12% 12% 12%
5 12% 9% 9%
6 5% 9% 8%
7 9% 7%
8 4% 6%
9 6%
10 6%
11 4%
Totals 100% 100% 100% 100%

A $25,000 increase in net working capital will be required to support the new machine. The firm plans to evaluate the potential replacement over a 4-year period. They estimate that the old machine could be sold at the end of 4 years to net $15,000 before taxes. Calculate the terminal cash flow at the end of year 4 that is relevant to the proposed purchase of the new machine. The firm is subject to a 40 percent tax rate on both ordinary and capital gains income.

Assuming new machine is bought at the beginning of 4th year
Depreciation in the year 1 of the machine

Cost of the machine= $200,000
Installation cost= $30,000
$230,000 Installation cost is capitalized
depreciation in the first year
@20% $46,000

Terminal cash flow at the end of 4 years

Cost of machine= ($200,000) (negative values are outflows, shown in red and within brackets)
Installation cost= ($30,000)
Capital gains on the sale of the machine 15000
Tax on capital gains @ 40 % ($6,000)
Tax shield on depreciation @ 40 % of 46 000 $18,400
Increase in net working capital ($25,000)
($227,600)

There is a total outflow of $227,600 at the end of 4 ...

Solution Summary

There are two problems.
The first problem ( Russell Industries) deals with machine replacement decision. The concept of MACRS depreciation is incorporated.
The second problem ( Norwich Tool's Lathe Investment Decision) deals with investment decision. Capital budgeting criteria like Payback, NPV, IRR are used. Also decisions under capital rationing and unlimited funds considered.

$2.19