Georgia Energy is contemplating replacing an oil powered generator with a solar

Question

Georgia Energy is contemplating replacing an oil powered generator with a solar powered generator. The old generator was purchased twenty two years ago and is being depreciated over its 25 year life to a zero salvage value using straight-line depreciation.  The old generator has a book value of $4.5 million but could be sold today for $3.0 million. The solar powered generator would cost $10 million and be depreciated over a 4 year life using MACRS (.33,.45,.15,.07). Do to the rapidly changing technology it is anticipated that the new generator will be sold after three years for $1.0 million. The new generator is expected to save Georgia Energy $10 million a year during its 3-year life. Georgia Energy will need to increase working capital by $1.5 million. The company

Explanation / Answer

Please find below the snapshot of the workings:

A couple of things explained:

1. Depreciation tax shield = depreciation for that year * tax rate

2. Tax credit on old machine = (book value - salvage value)*tax rate = (4.5 million - 3 million)*35%

3. Tax on salvage value of new machine = (salvage value - book value)*tax rate = (1,000,000-700,000)*35%

4. Discounting factors are 1, 1/1.1^1, 1/1.1^2, 1/1.1^3

Final NPV = 12,735,030

As this is positive, the company should replace the oil powered generator.

Hope this helped ! Let me know in case of any queries.

Year 0 Year 1 Year 2 Year 3 MACRS % 33% 45% 15% Depreciation 3,300,000 4,500,000 1,500,000 Book value after 3 years 700,000 New machine cost -10,000,000 Working capital -1,500,000 Pre-tax savings 10,000,000 10,000,000 10,000,000 Post-tax savings 6,500,000 6,500,000 6,500,000 Depreciation tax shield 1,155,000 1,575,000 525,000 Old machine salvage value 3,000,000 Tax credit on sale of old machine 525,000 Salvage value of new machine 1,000,000 Tax on salvage value of new machine -105,000 Return of working capital 1,500,000 Total cashflows -7,975,000 7,655,000 8,075,000 9,420,000 Discounting at 10% WACC 1.0000 0.9091 0.8264 0.7513 Discounted cashflows -7,975,000 6,959,091 6,673,554 7,077,385 NPV 12,735,030

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