The Chang Company is considering the purchase of a new machine to replace an obs

Question

The Chang Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has a book value and a market value of zero. However, the machine is in good working order and will last at least another 5 years. The proposed replacement machine will perform the operation so much more efficiently that Chang’s engineers estimate that it will produce after-tax cash flows (labor savings and depreciation) of $11,100 per year. The new machine will cost $33,300 delivered and installed, and its economic life is estimated to be 5 years. It has zero salvage value. The firm’s WACC is 7.20%, and its marginal tax rate is 40%. Calculate the NPV of the replacement analysis?

Explanation / Answer

In the given case, we will have to calculate the NPV of the replacement machine to determine as to whether the new machine should be purchased or not. The NPV is the difference between the present value of cash inflows/savings and cash outflows. The formula for calculating NPV is given below:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+WACC)^1 + Cash Flow Year 2/(1+WACC)^2 + Cash Flow Year 3/(1+WACC)^3 + Cash Flow Year 4/(1+WACC)^4 + Cash Flow Year 5/(1+WACC)^5

__________

Solution:

Using the values provided in the question, we get,

NPV = -33,300 + 11,100/(1+7.20%)^1 + 11,100/(1+7.20%)^2 + 11,100/(1+7.20%)^3 + 11,100/(1+7.20%)^4 + 11,100/(1+7.20%)^5 = $11,569.51 (answer)

Since, the NPV is positive, the replacement machine can be bought.

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