The Balboa Bottling Company is thinking of replacing an existing bottling machine with a newer and more efficient one. The current machine has a book value of $600,000 and a remaining useful life of 5 years, with annual depreciation of $120,000 per year. The firm doesnât expect that there will be any salvage value in 5 years, but another company in the industry has offered $250,000 for the machine now.
The new machine will cost $1.2 million and have a useful life of 5 years. The asset can be depreciated using the MACRS 5-yr schedule (20%, 32%, 19%, 12%, 11%, 6% respectively) and will have an estimated salvage value of $200,000 at the end of 5 years. By using the new machine, the firm will have cost savings of $275,000 per year. The marginal corporate tax rate is 30% and the WACC is 12.5%.
1. What is the cash flow at time 0 if the new machine is purchased and the old one is replaced?
2. What is the annual depreciation allowance for both machines? Determine the incremental depreciation expense if the old machine is replaced.
3. What are the operating cash flows for years 1-5 if the old machine is replaced?
4. Should the firm buy the new machine? Support your answer.
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