Suppose you have to decide whether selling an old machine or keeping it with a m

Question

Suppose you have to decide whether selling an old machine or keeping it with a major overhaul:

A) Selling the machine at time zero for $750,000 with zero book value and paying the tax of 40%.

B) Keeping the machine, which requires a major overhaul cost of $1,000,000 at time zero. The overhaul cost is depreciable from time 0 to year 5 (over six years) based on MACRS 5-year life depreciation with the half year convention (table A-1 at IRS). In this case machine can produce and generate equal annual revenue for five years (year 1 to 5) and salvage value of the machine will be $250,000 with zero book value at the end of year 5. The operating cost of the machine will be $400,000 per year from year 1 to year 5.

Calculate the minimum annual revenue that machine has to generate to break-even the selling with NPV of keeping the machine. Consider 40% income tax rate and after-tax minimum ROR of 14%.

Explanation / Answer

Selling ath the machine at time zero for $750,000 with zero book value would leave after tax cashflslow

0f 750,00*(1-.4) =450,000

NOV of these cashflows = 1293257.43

Now let us assume annual revenues x

Nov of annuiy x for five years at dicsount are of 14% is 3.43*x

as we have to calculate after tax cashflows = 3.43*x*.06

3.43*x*.06- 1293257.43= 450,000

Solving these x =8470638

0 1 2 3 4 5 Revenues Cost 4,00,000 4,00,000 4,00,000 4,00,000 4,00,000 Depreciation 20% 32% 19.20% 11.52% 11.52% Depreciation 200000 320000 192000 115200 115200 PBT -6,00,000 -7,20,000 -5,92,000 -5,15,200 -5,15,200 Tax -240000 -288000 -236800 -206080 -206080 PAT -3,60,000 -4,32,000 -3,55,200 -3,09,120 -3,09,120 Capita investment -1000000 Cashflows -1,60,000 -1,12,000 -1,63,200 -1,93,920 -1,93,920 After Tax Cashflows
from selling machine 150000 Total cashflows -1000000 -1,60,000 -1,12,000 -1,63,200 -1,93,920 -43,920

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