Gamma Inc. is considering the replacement of an existing machine. The new machine costs $1.8 million and requires installation costs of $250,000. The existing machine can be sold currently for $125,000 before taxes. The existing machine is 3 years old, cost $1 million when purchased, and has a $290,000 book value and a remaining useful life of 5 years. It was being depreciated under MACRS using a 5-year recovery period. If it is held for 5 more years, the machine’s market value at the end of year 5 will be zero. Over its 5-year life, the new machine should reduce operating costs by $650,000 per year, and will be depreciated under MACRS using a 5-year recovery period. The new machine can be sold for $150,000 net of removal and cleanup costs at the end of 5 years. A $30,000 increase in net working capital will be required to support operations if the new machine is acquired. The firm has adequate operations against which to deduct any losses experienced on the sale of the existing machine. The firm has a 15% cost of capital, is subject to a 40% tax rate and requires a 42-month payback period for major capital projects.
Should they accept or reject the proposal to replace the machine? What is the NPV? What is the IRR? What is the payback period?
Use the following table for depreciation:
Year 1 20%
Year 2 32%
Year 3 19%
Year 4 12%
Year 5 12%
Year 6 5%
Use the Excel template on the class webpage (Capital Budgeting Template.xls) and analyze the scenario above.
Answer the questions (Should they accept or reject the proposal to replace the machine? What is the NPV? What is the IRR? What is the payback period?)