One year ago your company purchased a machine for $110,000. You have learned tha
ID: 2651512 • Letter: O
Question
One year ago your company purchased a machine for $110,000. You have learned that the new, much better machine is available for $150,000. In will be depreciated on a straight line basis and has no salvage value. You expect the machine to produce $60,000 per year in revenue and cost $20,000 per year to operate for the next ten years. The current machine is expected to produce $40,000 per year in revenue and also costs $20,000 per year to operate. The current machine’s depreciation expense is $10,000 per for the next 10 years, after which it will be discarded. It will have no salvage value. The market value of the current machine today is $50,000. Your company’s tax rate is 45% and the opportunity cost of capital is 10%. Should your company replace its year-old machine?
Explanation / Answer
- Calculation of Incremental Initial Cash Outflow
Cost of new machine = $150,000
Scrap value of old machine = $50,000
Book Value of old machine = 110,000 - 10,000 = $100,000
Tax savings on loss of sale of asset = (100,000 - 50,000) x 45% = $22,500
Incremental Cash Outflow = 150,000 - 50,000 - 22,500 = $77,500
- Calculation of Incremental Cash Flow
Incremental contribution = (60,000 - 20,000) - (40,000 - 20,000) = $20,000
Incremental Depreciation = (150,000/10) - (100,000/10) = $5,000
Incremental Cash Flows = [(20,000 - 5,000) x (1 - 0.45)] + 5,000 = $13,250
- NPV = -77,500 + 13,250 x PVAF(10%, 10years) = -77,500 + (13,250 x 6.145) = $3,915.51
Since, the NPV is positive the company should replace its old machine.
Note: For the value of PVAF please refer PVAF table.
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