example #2 -- Answer all four questions (A-D). For question D, be sure to refer to both the NPV and the IRR.

example #6 -- calculate the initial cash flow, the operating cash flows, the terminal cash flow, the net present value (NPV), and the internal rate of return (IRR). When making your investment decision, be sure to refer to both the NPV and the IRR.

Example #2 Replacement Analysis

The Orange Fizz Company is contemplating the replacement of one of its bottling machines with a newer and more efficient one. The old machine has a book value of $500,000 and a remaining useful life of 5 years. It can be sold today for $200,000. The firm does not expect to realize any return from scrapping the old machine in 5 years. The old machine is being depreciated toward a zero salvage value, or by $100,000 per year, using the simplified straight-line method.

The new machine has a purchase price of $1.2 million, an estimated useful life and MACRS recovery period of 5 years. At the end of 5 years, the company expects to sell the new machine for $175,000. It is expected to economize on electric power usage, labor, and repair costs, and also to reduce the number of defective bottles. In total, an annual savings of $275,000 will be realized if it is installed.The company is in the 40 percent federal-plus-state tax bracket, and it has a 10 percent cost of capital.

A. What is the initial cash flow?

B. What are the operating cash flows?

C. What is the terminal cash flow?

D. Should the firm purchase the new machine? Why or why not?

Example #6 Replacement Project Analysis

The Durst Equipment Company purchased a machine 5 years ago at a cost of $100,000. It had an expected life of 10 years at the time of purchase and an expected sale price of $10,000 at the end of the 10 years. It is being depreciated by the straight-line method toward a salvage value of $10,000. This results in annual depreciation of $9,000. It can be sold today for $65,000.

A new machine can be purchased for $150,000 including installation costs. Over its 5-year life, it will reduce cash operating expenses by $50,000 per year.Sales are not expected to change.At the end of its useful life, the machine is estimated to be worthless. MACRS depreciation will be used, and it will be depreciated over a 3-year recovery (rather than its 5-year economic life). The firm's tax rate is 34 percent. The cost of capital is 15 percent. Should the company replace the old machine? Why or why not?

MACRS Depreciation Schedule

Ownership Class of investment

Year3-year 5-year 7-year 10-year

133% 20% 14% 10%

245 32 25 18

3 15 19 17 14

4 7 12 13 12

511 9 9

6 6 9 7

7 9 7

8 4 7

9 7

106

113