Reference no: EM132412360

The MegaCuts company purchased a paper cutting machine for $600,000 four years ago.  Now, it is considering replacing this machine with a new one in order to reduce its costs.  For tax purposes, the firm was going to depreciate the old machine to a salvage value of 0 over 6 years.  This machine can be used in the production for another four years.  The operating costs are $175,000 per year.  This machine can be sold today for $325,000. At the end of its economic life (i.e., at the end of year 4), the firm estimates that this machine can be sold for $50,000. The new cutting machine will cost the firm $750,000 today, and will be depreciated towards a salvage value of 0 in four years.  This machine can be used for four years in the production process. At the end of year 4, it can be sold for $250,000. The operating costs of this machine will be $50,000 per year (a cost reduction of $125,000 per year).  Since the new machine will break down for fewer times, the firm does not have to carry as much inventory as it does with the old machine. Therefore, the inventory level is estimated to decline by $5,000 at t=0 and by another $15,000 at t=1. Last year, the firm spent $25,000 to test the new machine in its production process. The firm is in 34% tax bracket.  The MegaCuts'cost of capital is 11%.

a. Calculate the initial investment at t=0, operating cash flows at t=1, 2, 3, 4 and the termination cash flows at t=4.

b. Determine whether the MagaCuts should replace its paper cutting machine or not.