Otter must decide whether to replace a 10 year-old packing machine with a new on

Question

Otter must decide whether to replace a 10 year-old packing machine with a new one that costs$153,800. Replacing the old machine will increase net operating income(excluding depreciation) from$70,000 to $110,000 and it will decrease net working capital by $18,000. The new machine falls into MACRS 5-year class. If the new machine is purchased, it will be sold in 6 years for $25,000, whereas, if the old machine is kept, it will have no salvage value in 6 years. The old machine has a current market value of $10,860 and although its current book value is $8,000, in one year the old machine’s book value will be zero ($0). The firm’s marginal tax rate is 40% and its required rate of return is 12%. Should the new packing machine be purchased? Explain.

Depreciation

            NEW                          OLD

Year 1 -$22,760                 $ 8,000

Year 2 - $49,216                $ 0

Year 3 - $29,222                $ 0

Year 4 - $18,456                $ 0

Year 5 - $ 16,918               $ 0

Year 6 - $9,228                   $ 0

note*

tax cost of $1144 on disposal of the old machine ( 10,860 - 8000 X 40% )

The new depreciation for year 1 is $ 30,760 not 22,760 as stated , which makes the change in depreciation $ 22,760.

Explanation / Answer

Discount rate 12% New repacing machine Year 0 1 2 3 4 5 6 Initial cost -153800 Increase in net operating income 40000 40000 40000 40000 40000 40000 Networking capital benefit 18000 18000 18000 18000 18000 18000 Salvage value 25000 Net cf -153800 58000 58000 58000 58000 58000 83000 Tax@40% -153800 34800 34800 34800 34800 34800 49800 Present value@12% -153800 31071.43 27742.35 24769.95 22116.03 19746.45 25230.23 NPV -3123.56 Old machine Year 0 NPV 10860 Tax 1144 Post tax cash inflow 9716 The new machine will be worthless after 6 years So as per analysis we should not consider using new machine as the NPV is negative The benifit of new machine is not going above its cost

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