Example #5 Replacement Project Analysis

The Erickson Toy Corporation currently uses an injection molding machine that was purchased 2 years ago. It has a depreciable base of $2600. The machine is being depreciated on a straight-line basis toward a $500 salvage value, and it has 6 years of life remaining. This results in annual depreciation of $262.50. The old machine can be sold today for $2,000.

The firm is offered a replacement machine that has a cost of $8,000 and an estimated useful life of 6 years. After 6 years, Erickson expects to sell the replacement machine for $800.The machine has a MACRS 5-year recovery period. The replacement machine would permit an output expansion, so sales would rise by $1,000 per year. Even so, the new machine's much greater efficiency would still cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500.

The firm's marginal federal-plus-state tax rate is 40% and its cost of capital is 15%. Should it replace the old machine?

Answer the below: show work

1. Initial cash flow

2. operating cash flow

3 Terminal cash flow

4 NPV/ IRR