Pacific Manufacturing is considering the replacement of a machine, which it purchased 3 years ago, with a newer and more efficient model. The existing machine has a book value of $2100.00 and is expected to last 6 more years at which point Pacific Manufacturing expects to scrap it for an amount equal to the cost of disposal. It is being depreciated on a straight-line basis (to a salvage of ) and a competitor has offered $2,500.00 for the old machine.
The new machine will cost $9,000.00 with an estimated life of 6 years and an anticipated scrap value equal to disposal costs. Depreciation will be computed using a 5-year MACRS schedule and a salvage value. (Depreciation percentages are: 20%, 32%, 19%, 12%, 11% and 6% for years 1-6 respectively.) Pre-tax operating cash savings, due to reduced material and labor costs, are estimated at $1000.00 per year.
The machine will also permit the production and sale of a new product that will increase net pre-tax operating returns by $1250.00 per year in addition to the cost savings on existing products. The greater sales volume will require $2,750.00 in additional working capital, which can be partially financed through an increase of $750 in accounts payable. Pacific Manufacturing is in the 34 percent tax bracket and uses a 14% cost of capital.
a. What is the net initial cash outlay for the new machine?
b. What are the net cash flows for years 1-6?
c. What is the change in cash flow in year 6?
d. Should Pacific Manufacturing purchase the new machine? Why?
e. Now assume there is no old machine and you are interested in purchasing the new machine with expected net operating earnings before depreciation of $3,750.00 per year. Would you buy the machine? Why?
Hint: Year 1 depreciation taxshield =$493