The capital budgeting process includes both expansionary type problems and replacement problems. In this activity, we consider a replacement problem. In a replacement problem, we are interested in evaluating whether a new machine/asset offers enough benefits in terms of future cash flows to justify the capital expenditure. The key to completing this type of analysis is the concept of incremental. This means we want to think in terms of subtracting the old cash flows on the existing machine from the net cash flows on the new machine. Commonly, in this type of a problem, we will assume that the impact on sales revenue is zero and that the analysis comes down to weighing the costs of the new machine against the expense reduction offered by the new machine. For each machine, we again develop the free cash flows as follows:
Free Cash Flows = [EBIT(1-tax rate) + Depreciation and Amortization] – [Additional capital expenditures – additional net working capital]
The EBIT is defined as sales fewer variables, expenses less fixed expenses, less depreciation. We form the FCFs for each machine for each year into the future, and then the difference these future FCFs make to generate the incremental cash flows.
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Assume that a company’s machine was bought 10 years ago at a cost of $200,000. The machine had an expected life of 20 years at the time it was bought with a $0 salvage value. The annual depreciation expense is $10,000 and the current book value is $100,000. The market value of this machine is $90,000. A company is considering buying a new machine that costs $140,000, which has a projected 10-year life. The new machine is expected to reduce the firm’s operating expenses from $30,000 to $12,000. With the new machine, the firm’s pre-tax profits are anticipated to increase by $18,000 per year. If the company buys this new machine, the old machine will be sold. It’s projected that the new machine can be sold for $5,000 at the end of its life. The cost of capital is calculated based upon funding from retained earnings and from debt. The company is assumed to fund itself with 40% debt and 60% retained earnings. The cost of debt capital, rD, is 8%. The cost of capital from retained earnings, rS, is based upon the Capital Asset Pricing Model. The risk-free rate in the market is 3% and the difference between the expected return on the market and the risk-free rate is 5%. The beta of the company is 1.5. The tax rate is assumed to be 35%. Should the company buy a new machine? Please justify your answer. Please use Excel for the calculations. Please write your answers to the qualitative question in an MS Word document and paste your spreadsheet work into the Word document.
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