Apr 102010

Q4) SHARK, a large manufacturer of aircraft components, is trying to determine whether to replace an old machine with a new, more sophisticated model. The new machine’s purchase price is $320,000 and an additional $25,000 will be necessary to install it. It will be depreciated under using a 5-year recovery period. The existing old Machine was bought 1 year ago and costs $180,000 and installation costs of $20,000. The firm has found a buyer willing to pay $220,000 for the present machine and remove it at the buyer’s expense. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement. Estimates of its revenue and expenses (excluding depreciation and interest) are provided below. The firm expects to be able to liquidate the new machine at the end of its 3 years net $200,050 after paying removal and cleanup costs. The old machine can be liquidated as the end of the 3 years to net $35,000. The firm expects to recover its $17,000 net working capital investment upon termination of the project. Corporation tax rate is 40%.

Depreciation will be based on the Modified Accelerated Cost Recovery System (MACRS):
Year 1 at 20%
Year 2 at 32%
Year 3 at 19%
Year 4 at 12%
Year 5 at 12%
Year 6 at 5%

Revenue & Expenses Estimates: (Excluding Depreciation)
Old Machine:
Year 1: 3 Million Revenue. 2.5 Million Expenses
Year 2: 3.1 Million Revenue. 2.6 Million Expenses
Year 3: 3.2 Million Revenue. 2.7 Million Expenses
New Machine:
Year 1: 4 Million Revenue. 3 Million Expenses
Year 2: 4.1 Million Revenue. 3.1 Million Expenses
Year 3: 4.2 Million Revenue. 3.2 Million Expenses

Using a cost of capital of 10%

A) Would you recommend replacing the old machine and why? (Easy)
B) Calculate the payback period for the new machine. (Super Easy)
C) What would be the minimum rate of return SHARK would require for the new machine?

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