Boulder Mountain Chemical Corporation (BMCC) is a Texas based producer and distributor of a broad range of industrial chemicals. BMCC’s Chief production engineer, Rocky Cliffs is considering replacing the packaging machines at its Houston distribution facility. The current packaging machines were purchased 6 years ago at a cost of $1.6 million. At that time, they were classified under the 15-year MACRS depreciation category and have been depreciated accordingly for the past 6 years. Rocky thinks that these machines could be used for as many as 7 more years. If they are used for the next 7 years, it is estimated that the machines could be sold at that time for $125,000.

The new packaging machines under consideration would cost $3.6 million to purchase and install. These new machines would also be depreciated under the 15 year MACRS schedule. These new machines are estimated to be able to produce pre-tax cash operating savings of $1.1 million for each of the next 7 years at which time they are expected to be replaced. It is believed that, at that time, the new machines could be sold for $1.6 million. Since these new machines are believed to be more efficient at packaging the firm’s products, Rocky estimates that it will need to make a fully recoverable investment of $30,000 in additional inventory balances. Simultaneously, because of trade credit, Boulder’s accounts payables balance would increase by $10,000.

Should Boulder continue operating its existing packaging machinery, it will incur a one-time cash expense of $750,000 to repair damage its machines suffered as a result of a particularly strong thunderstorm. With these repairs to existing machinery, Boulder will incur annual cash operating expenses of $4.9 million. Should Boulder elect to upgrade its packaging machinery, it will sell its existing machines today for $300,000.

With either packaging equipment, BMCC will produce revenues of $10 million per year for the next 7 years.

BMCC pays income taxes at a marginal rate of 40% and assigns a required return of 8% for this project.

Being something of a simpleton, Rocky asks for your assistance in evaluating this proposal. He asks you to complete the following items for analysis.

1) Determine the required rate of return that would make Boulder indifferent between the two alternatives.