Problem 3 (40 points)

XYZ Industries is considering the following project: Buying a new machine to replace an older machine. The new machine costs $1,500,000 right now and can be sold at the end of its life in 6 years for $200,000. The old machine was purchased 7 years ago for $1,000,000 and can be sold for $300,000 today or for $100,000 in 6 years. Both, the old and the new machines have a CCA rate of 30%. XYZ Industries has just paid $110,000 for a study which indicates that the new machine will reduce annual manufacturing expenses by $400,000 per year. Since the new machine is more reliable, the plant will need to keep fewer spare parts in stock. Management expects that inventory levels can be reduced by $70,000 (at t=0) when the new machine is installed (note, at the end of the project, this change in net working capital will be reversed, i.e., inventory levels will increase again by $70,000 at the end of year 6). XYZ's marginal tax rate is 36%, and its required rate of return (RRR) is 11%.

1. a) What is the initial cash outlay (the total cash flow at t=0)? --> What is the step by step solution ?
2. b) What is the second year's cash flow (excluding the CCA Tax Shield)? --> What is the step by step solution ?
3. c) What is the last year's cash flow (excluding the CCA Tax Shield)? --> What is the step by step solution ?
4. d) What is the year 5 CCA? --> What is the step by step solution ?
5. e) What is the PV CCA Tax Shield? --> What is the step by step solution ?
6. f) What is the NPV of the replacement project? --> What is the step by step solution ?

a) Calculation of Initial cashflow:

A: Cost of new machine = -$1,500,000

B: Sale proceeds from old machine:

Salvage Value = $300,000

Book Value = $82,354.30*

*Calculation of book value of old machine at Year 0 for tax purpose: TABLE 1

Capital Gain = Salvage Value - Book Value = $300,000 - $82,354.3 = $217,645.70

Tax on capital gain @ 36% = Capital Gain * tax rate = $217,645.70 * 36% = $78,352.45

Net proceeds from sale of old machine = Salvage Value - Tax = $300,000 - $78,352.45 = $221,647.55

C: Working Capital: Decrease in working capital = $70,000

Total Initial cashflow: A+B+C = -$1,500,000 + $221,647.55 + $70,000 = -$708,352.45

b) Calculation of second year cashflow:

A: Saving in annual manufacturing expenses = $400,000

B: Tax on saving at 36% = $400,000 * 36% = $144,000

Net Cashflow after tax = A-B = $400,000 - $144,000 = $256,000

c) Calculation of last year cashflow:

A: Net Cashflow after tax (calculated in part b) = $256,000

B: Outflow from increase in working capital = -$70,000

C: Sale proceeds from sale of machine:

Salvage Value = $200,000

Book Value = $176,473.50*

*Calculation of book value of new machine at EOY 6 for tax purpose: TABLE 2

Capital Gain = Salvage Value - Book Value = $200,000 - $176,473.50 = $23,526.50

Tax on capital gain @ 36% = Capital Gain * tax rate = $23,526.50 * 36% = $8,469.54

Net proceeds from sale of old machine = Salvage Value - Tax = $200,000 - $8,469.54 = $191,530.46

Last year cashflow = A+B+C = $256,000 - $70,000 + $191,530.46 = $377,530.46

d) Calculation of 5 year CCA: TABLE 3

Year 5 CCA = $ 108,045

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