8. Replacement analysis Green

8. Replacement analysis

Green Moose Industries is a company that produces iGadgets,among several other products. Suppose that Green Moose Industriesconsiders replacing its old machine used to make iGadgets with amore efficient one, which would cost $1,700 and require $380annually in operating costs except depreciation. After-tax salvagevalue of the old machine is $700, while its annual operating costsexcept depreciation are $1,000. Assume that, regardless of the ageof the equipment, Green Moose Industries’s sales revenues are fixedat $4,500 and depreciation on the old machine is $700. Assume alsothat the tax rate is 40% and the project’s risk-adjusted cost ofcapital, r, is the same as weighted average cost of capital (WACC)and equals 10%.

Based on the data, net cash flows (NCFs) before replacementare__________ , and they are constant over four years.

Although Green Moose Industries’s NCFs before replacement arethe same over the 4-year period, its NCFs after replacement varyannually. The following table shows depreciation rates over fouryears.

Year 1

Year 2

Year 3

Year 4

Depreciation rates 33.33% 44.45% 14.81% 7.41%

Complete the following table and calculate incremental cashflows in each year. Hint: Round your answers to the nearest dollarand remember to enter a minus sign if the calculated value isnegative.

Year 0

Year 1

Year 2

Year 3

Year 4

New machine cost $1,700
After-tax salvage value, old machine $700
Sales revenues $4,500 $4,500 $4,500 $4,500
Operating costs except depreciation $380 $380 $380 $380
Operating income $ $ $ $
After-tax operating income $ $ $ $
Net cash flows after replacement (adding backdepreciation) $ $ $ $
Incremental Cash Flows $ $ $ $ $

Next evaluate the incremental cash flows by calculating the netpresent value (NPV), the internal rate of return (IRR), and themodified IRR (MIRR). Assume again that the cost of financing thenew project is the same as the WACC and equals 10%. Hint: Use aspreadsheet program’s functions or use a financial calculator forthis task.





Based on the evaluation, replacing the old equipment appears tobe a________(good/bad) decision because____________(the MIRR islower than the IRR/ the NPV is negative/ the IRR is small).



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