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. Mathamatical formula please!

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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