BA 340
Final review questions’ solutions
1. Degnan Dance Company, Inc., a manufacturer of dance and exercise apparel, is considering replacing an
existing piece of equipment with a more sophisticated machine. The following information is given.
Existing Machine Proposed Machine
_________________________________________________________________
Cost = $100,000 Cost = $150,000
Purchased 2 years ago Installation = $20,000
Depreciation using MACRS over Depreciation—the MACRS
a 5-year recover schedule 5-year recovery schedule will be used.
Current market value = $105,000
Five year usable life remaining Five year usable life expected
Earnings Before Depreciation and Taxes
Existing Machine Proposed Machine
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Year 1 $160,000 Year 1 $170,000
2 150,000 2 170,000
3 140,000 3 170,000
4 140,000 4 170,000
5 140,000 5 170,000
The proposed machine would be sold at book value at the end of the fifth year. The existing machine would
be discarded after its remaining useful life if it was maintained. No working capital investment is required.
The firm’s cost of capital is 10% and its tax rate is 40%. Should the new machine be purchased?
Solution: Since we are evaluating just one project, we can use NPV.
The required rate of return is 10%
Incremental cash flows:
Proposed machine:
Initial cash flows: Purchase price + installation = $170,000
Operating cash flows:
Using a 5-yr MACRS schedule, depreciation for the proposed machine for 5 years is:
Yr. 1: 170000 * 0.2 = 34000
2: 170000 * 0.32 = 54400
3: 32640
4: 19580
5: 19580
OCFs: Yr 1 2 3 4 5
EBDepr 170000 170000 170000 170000 170000
– Depr 34000 54400 32640 19580 19580
EBIT 136000 115600 137360 150420 150420
-taxes 54400 46240 54948 60168 60168
+Depr 34000 54400 32640 19580 19580
OCF 115600 123760 115052 109832 109832
Terminal cash flow:
Sale of proposed machine (at book value):
Book value = 170000 – 34000 – 54400 – 32640 – 19580 – 19580 = 9800
Existing machine:
Sale of existing machine (included in initial cash flows):
Book value = 100000 – (100000 * 0.2) – (100000 * 0.32) = 48000
Cash flow from sale: 105000 – (105000 – 48000) * 0.4 = 82200
Operating cash flows lost:
The existing machine is to be used for 5 more years:
Depreciation:
Yr. 1: 100000 * 0.192 = 19200
2: 100000 * 0.1152 = 11520
3: 100000 * 0.1152 = 11520
4: 100000 * 0.0576 = 5760
5: 0
