Galveston shipyards is considering the replacement of an eight year old riveting

Question

Galveston shipyards is considering the replacement of an eight year old riveting machine with a new one that will increase earnings before depreciation and taxes from $27,000 to $54,000 per year. The new machine will cost $82,500, and it will have an estimated life of eight years and no salvage value. The new machine will be depreciated over its 5 years MACRS recovery period ( year1 20%, 2 32%, 3 19%, 4 12%, 5 11%, 6   6%) THe firms marginal tax rate is 40%, and the firms required rate of return is 12%. The old machine has been fully depreciated and has no salvage value. Should the old riveting machine be replaced by the new one? Show all work for full rating.

Explanation / Answer

First you need to get the annual cash inflow from the project, after tax, then get each year's Present Value, using a discount rate of 12%. Compare the total PV of the future cash flows with the investment of 82,500. If the net is positive, its a good investment.

Earnings will increase by 27,000 per year before tax and depreciation. At a tax rate of 40%, that is a positive annual cash flow of 16,200 before the tax benefit of depreciation. Using MACRS rates, get the depreciation amount in yrs 1 - 6, x 40%, to get the additional cash flow from the tax saved on depreciation. Add that amount to each of the first 6 yrs cash flow of 16,200. Then get the PV of each year's total cash flow to compare to the investment.

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