You currently have a machine that was purchased four years ago. The depreciation

Question

You currently have a machine that was purchased four years ago. The depreciation deduction is $30,000 in the next year and $15,000 in the year after. Then the book value becomes zero. The original cost was $150,000, and the machine can last for 10 years or more in its current application. A new machine is now available at a cost of only $100,000. The depreciation deductions are as follows: $20,000 in year 1; $32,000 in year 2; $19,200 in year 3; $11,520 in year 4 and $5,760 in year 5. The annual expenses of the challenger are only $5,000, while those of the defender are $20,000. The challenger has a useful life greater than 10 years. You find that $40,000 is the best price you can get if you sell the present machine now. Your best projection for the future is that you will need the service provided by one of the two machines for the next five years. The MV of the defender is estimated at $2,000 in five years, but that of the challenger is estimated at $5,000 in five years. If the after-tax MARR is 10% per year, should you sell the defender and purchase the challenger? You do not need both. Assume that the company is in the 40% income tax bracket.

a. sell the defender and NOT purchase the challenger

b. keep the defender and purchase the challenger

c. sell the defender and purchase the challenger

d. keep the defender and not purchase the challenger

Explanation / Answer

Benefit/ cost of Continuing with the Defender Option :1 year Depreciation Annual Cost Total Expense Taxes Total Cashflow PV factor PV of Cashflow 0 0 1 0 1 30000 20000 50000 -20000 0 0.909091 0 2 15000 20000 35000 -14000 -34000 0.826446 -28099.17355 3 20000 20000 -8000 -28000 0.751315 -21036.81443 4 20000 20000 -8000 -28000 0.683013 -19124.37675 5 18000 18000 -7200 -25200 0.620921 -15647.21734 NPV -83907.58207 Option:2 Benefit of selling Defender and buy challenger benefit from buying challenger year Depreciation Annual Cost Total Expense Taxes Total Cashflow PV factor PV of Cashflow 0 -100000 1 -100000 1 20000 5000 25000 -10000 -5000 0.909091 -4545.454545 2 32000 5000 37000 -14800 -19800 0.826446 -16363.63636 3 19200 5000 24200 -9680 -14680 0.751315 -11029.30128 4 11520 5000 16520 -6608 -11608 0.683013 -7928.42019 5 5760 0 5760 -2304 -2304 0.620921 -1430.602728 NPV -141297.4151 Benefit of selling Defender and buy challenger = -141297.4151-(-83907.58207) = - 57389.83 Since buying challenger & selling deffernder will result in less cashoutflow and will be prefered. Answer is "c"

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