392 Part 4 Investing in Long-Term Assets: Capital Budgeting
basis to zero over 5 years at the rate of $7,200 per year beginning the first year. (Thus,
annual cash flows would be $12,000 before taxes plus the tax savings that result from
$7,200 of depreciation.) The managers are having a heated debate about whether the
tractor would last 5 years. The controller insists that she knows of tractors that have lasted
only 4 years. The treasurer agrees with the controller, but he argues that most tractors do
give 5 years of service. The service manager then states that some last as long as 8 years.
Given this discussion, the CFO asks you to prepare a scenario analysis to determine
the importance of the tractor’s life on the NPV. Use a 40% marginal federal-plus-state tax
rate, a zero salvage value, and a 10% WACC. Assuming each of the indicated lives has the
same probability of occurring (probability " 1/3), what is the tractor’s expected NPV?
(Hint: Use the 5-year straight-line depreciation for all analyses and ignore the MACRS
half-year convention for this problem.)
NEW PROJECT ANALYSIS Holmes Manufacturing is considering a new machine that
costs $250,000 and would reduce pretax manufacturing costs by $90,000 annually. Holmes
would use the 3-year MACRS method to depreciate the machine, and management thinks
the machine would have a value of $23,000 at the end of its 5-year operating life. The
applicable depreciation rates are 33%, 45%, 15%, and 7% as discussed in Appendix 12A.
Working capital would increase by $25,000 initially, but it would be recovered at the end
of the project’s 5-year life. Holmes’s marginal tax rate is 40%, and a 10% WACC is
appropriate for the project.
a. Calculate the project’s NPV, IRR, MIRR, and payback.
b. Assume that management is unsure about the $90,000 cost savings—this figure could
deviate by as much as plus or minus 20%. What would the NPV be under each of
these situations?
c. Suppose the CFO wants you to do a scenario analysis with different values for the
cost savings, the machine’s salvage value, and the working capital (WC)
r equirement. She asks you to use the following probabilities and values in the
scenario analysis:Scenario Probability Cost Savings Salvage Value WC
Worst case 0.35 $ 72,000 $18,000 $30,000
Base case 0.35 90,000 23,000 25,000
Best case 0.30 108,000 28,000 20,000Calculate the project’s expected NPV, its standard deviation, and its coefficient of
variation. Would you recommend that the project be accepted? Why or why not?
REPLACEMENT ANALYSIS The Erley Equipment Company purchased a machine 5 years
ago at a cost of $90,000. The machine had an expected life of 10 years at the time of
purchase, and it is being depreciated by the straight-line method by $9,000 per year. If the
machine is not replaced, it can be sold for $10,000 at the end of its useful life.
A new machine can be purchased for $150,000, including installation costs. During its
5-year life, it will reduce cash operating expenses by $50,000 per year. Sales are not
expected to change. At the end of its useful life, the machine is estimated to be worthless.
MACRS depreciation will be used. The machine will be depreciated over its 3-year class
life rather than its 5-year economic life; so the applicable depreciation rates are 33%, 45%,
15%, and 7%.
The old machine can be sold today for $55,000. The firm’s tax rate is 35%. The appro-
priate WACC is 16%.
a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0?
b. What are the incremental net cash flows that will occur at the end of Years 1 through 5?
c. What is the NPV of this project? Should Erley replace the old machine? Explain.
REPLACEMENT ANALYSIS The Bigbee Bottling Company is contemplating the
replacement of one of its bottling machines with a newer and more efficient one. The old
machine has a book value of $600,000 and a remaining useful life of 5 years. The firm does
not expect to realize any return from scrapping the old machine in 5 years, but it can sell it
now to another firm in the industry for $265,000. The old machine is being depreciated by
$120,000 per year using the straight-line method.