The Bigbee Bottling Company is contemplating the replacement ofone of its bottling machines with a newer and more efficient one.The old machine has a book value of R600,000 and a remaining usefullife of 5 years. The company does not expect to realise any returnfrom scrapping the old machine in 5 years, but it can sell it nowto another company in the industry for R265,000. The old machine isbeing depreciated by R120,000 per year, using the straight-linemethod. The new machine has a purchase price of R1,175,000, anestimated useful life and MACRS class life of 5 years, and anestimated salvage value of R145,000. The applicable depreciationrates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected toeconomise on electric power usage, labour, and repair costs, aswell as to reduce the number of defective bottles. In total, anannual savings of R255,000 will be realised if the new machine isinstalled. The company’s marginal tax rate is 35% and it has a 12%WACC.
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Required:
4.1 What initial cash outlay is required for the new machine?(3)
4.2 Calculate the annual depreciation allowances for both machinesand compute the change in the annual depreciation expense if thereplacement is made. (5)
4.3 What are the incremental cash flows in Years 1 through 5?(5)
4.4 Should the company purchase the new machine? Support youranswer. (3)
4.5 In general, how would each of the following factors affect theinvestment decision, and how should each be treated?
4.5.1 The expected life of the existing machine decreases.(2)
4.5.2 The WACC is not constant, but is increasing as Bigbee addsmore projects into its capital budget for the year. (2)