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Example \#5 Replacement Project Analysis The Erickson Toy Corporation currently uses an injection molding machine that was purchased 2 years ago. It has a depreciable base of $2600. The machine is being depreciated on a straightline basis toward a $500 salvage value, and it has 6 years of life remaining. This results in annual depreciation of $262.50. The old machine can be sold today for $2,000. The firm is offered a replacement machine that has a cost of $8,000 and an estimated useful life of 6 years. After 6 years, Erickson expects to sell the replacement machine for $800. The machine has a MACRS 5 -year recovery period. The replacement machine would permit an output expansion, so sales would rise by $1,000 per year. Even so, the new machine's much greater efficiency would still cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500 The firm's marginal federal-plus-state tax rate is 40% and its cost of capital is 15%. Should it replace the old machine? Homework assignment #23 is taken from the class Capital Budgeting handout. A copy of the handout is attached. On page 7 of the handout, work example 45 , as follows 1. calculate the initial cash flow 2. calculate all of the operating cash flows 3 calculate the terminal cash flow 4 calculate the net present value (NPV) 5. calculate the internal rate of retum (IRR) When you make the decision of whether or not to replace the old machine, be sure to base it on BOTH the net present value (NPV) AND the internal rate of return (IRR)

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