The Boyd Bottling 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 $600,000 and a remaining useful life of five years. The firm does not expect to realize any return from scrapping the old machine in five years, but it can be sold today to another firm in the industry for $265,000. The old machine is being depreciated toward a $0 salvage value, or by $120,000 per year, using the straight line method.

The new machine has a purchase price of $1,175,000, an estimated useful life and MACRS class life of five years, and an estimated market value of $145,000 at the end of five years. (See Table 13A-2 at the end of this chapter for MACRS recovery allowance percentages.) The machine is expected to economize on electric power usage, labor, and repair costs, which will save Boyd $230,000 each year. In addition, the new machine is expected to reduce the number of defective bottles, which will save an additional $25,000 annually. The company’s marginal tax rate is 40 percent, and it has a 12 percent required rate of return.

a. What initial investment outlay is required for the new machine?

b. Calculate the annual depreciation allowances for both machines, and compute the change in the annual depreciation expense if the replacement is made.

c. What are the supplemental operating cash flows in Years 1 through 5?

d. What is the terminal cash flow in Year 5?

e. Should the firm purchase the new machine? Support your answer.

f. In general, how would each of the following factors affect the investment decision, and how should each be treated?

(1) The expected life of the existing machine decreases.

(2) The required rate of return is not constant but is increasing as Boyd adds more projects into its capital budget for the year.