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ABC Corporation is considering replacing one of its machines with a new, more efficient machine. The old machine was bought at $420,000 four years ago and can currently be sold for $200,000. The old machine is being depreciated on a simplified straight-line basis down to a salvage value of $25,000 in the next 6 years. The replacement machine would cost $540,000, and have an expected life of 6 years, after which it could be sold for $60,000. Because of reductions in defects and material savings, the new machine would produce cash benefits of $150,000 per year before depreciation and taxes.

Also, the replacement requires an initial investment in spare parts inventory of $25,000, along with an additional $20,000 in inventory for each succeeding year of the project. The inventory will be recovered when the project ends. Assume simplified straight-line depreciation, a 20 percent marginal tax rate, and a required rate of return of 5 percent.

1. What is the initial outlay associated with this project?

2. What are the operating cash flows associated with this project?

3. What is the terminal cash flow in year 6?

4. Should the old machine be replaced?

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