The Dauten Toy Corporation currently uses an injection moldingmachine that was purchased 2 years ago. This machine is being depreciated on astraight-line basis, and it has 6 years of remaining life. Its current book value is $2,100, andit can be sold for $2,500 at this time. Thus, the annual depreciation expense is $2,100/6 =$350 per year. If the old machine is not replaced, it can be sold for $500 at the end of itsuseful life.Dauten is offered a replacement machine which has a cost of $8,000, an estimateduseful life of 6 years, and an estimated salvage value of $800. This machine falls into theMACRS 5-year class so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%,and 6%. The replacement machine would permit an output expansion, so sales wouldrise by $1,000 per year; even so, the new machine’s much greater efficiency would causeoperating expenses to decline by $1,500 per year. The new machine would require thatinventories be increased by $2,000, but accounts payable would simultaneously increaseby $500. Dauten’s marginal federal-plus-state tax rate is 40%, and its WACC is 11%. Shouldit replace the old machine?
Depreciation Methods
The word "depreciation" is defined as an accounting method wherein the cost of tangible assets is spread over its useful life and it usually denotes how much of the assets value has been used up. The depreciation is usually considered as an operating expense. The main reason behind depreciation includes wear and tear of the assets, obsolescence etc.
Depreciation Accounting
In terms of accounting, with the passage of time the value of a fixed asset (like machinery, plants, furniture etc.) goes down over a specific period of time is known as depreciation. Now, the question comes in your mind, why the value of the fixed asset reduces over time.
The Dauten Toy Corporation currently uses an injection molding
machine that was purchased 2 years ago. This machine is being depreciated on a
straight-line basis, and it has 6 years of remaining life. Its current book value is $2,100, and
it can be sold for $2,500 at this time. Thus, the annual depreciation expense is $2,100/6 =
$350 per year. If the old machine is not replaced, it can be sold for $500 at the end of its
useful life.
Dauten is offered a replacement machine which has a cost of $8,000, an estimated
useful life of 6 years, and an estimated salvage value of $800. This machine falls into the
MACRS 5-year class so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%,
and 6%. The replacement machine would permit an output expansion, so sales would
rise by $1,000 per year; even so, the new machine’s much greater efficiency would cause
operating expenses to decline by $1,500 per year. The new machine would require that
inventories be increased by $2,000, but accounts payable would simultaneously increase
by $500. Dauten’s marginal federal-plus-state tax rate is 40%, and its WACC is 11%. Should
it replace the old machine?
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