Tennergy Corp is considering an investment in a new machine with a price of $40 million to replace its existing machine. The current machine was purchased one year ago at $10 million and depreciated on a straight line basis to zero salvage value over five-year useful life. It currently has a market value of $8.5 million. The new machine is expected to have a four-year life. If the firm replaces the old machine with the new machine, it expects to save $5.5 million in operating costs each year over the next four years. Both machines will have no salvage value in four years. If the firm purchases the new machine, it will also need an investment of $450,000 in net working capital. The required return on the investment is 12 percent, and the tax rate is 35 percent.
a. What is the initial cost of this replacement?
b. What is the amount of change in the earnings before interest and taxes for the first year of this replacement?
c. What is the operating cash flow generated by the replacement?
d. What is the amount of the terminal cash flow after the net working capital is recovered?
e. What is the internal rate of return of this replacement?
The solution explains the calculation of cash flows and internal rate of return for a replacement decision