. The great tech company is considering replacing one of its machines with a mor
ID: 2801723 • Letter: #
Question
. The great tech company is considering replacing one of its machines with a more efficient one. The old machine has a book value of $60,000 and a remaining useful life of 5 years. It can sell the old machine now for $ 265,000. The old machine is being depreciated by 120,000 per year straight line. The new machine has a purchase price of $ 1,175,000 an estimated useful life and 5 years MACRS class life and salvage value of $145,000. Annual economic savings is $255,000 if new machine is installed. Taxes 35% and WACC is 12.
a. Calculate the NPV and IRR of the project and make a decision.
b. If expected life of existing machine decreased what effect does this have on the cash flow, discuss only?
c. If R&D were $30,000, what effect on NPV? Discuss only.
Explanation / Answer
After-tax salvage: Cost of new m/c 1175000 Acc.depn.upto Year 5(94.24%*1175000) 1107320 Carrying value at end yr.5 67680 sale value 145000 Capital gains 77320 Tax at 35% on gain 27062 So, after-tax salvage(145000-27062)= 117938 NPV of the decision will be Depn. Tax shield that will be lost for the old machine +Sale value of the old m/c -Purchase cost of new m/c +PV of After-tax economic savings for new m/c for 5 yrs +After-tax salvage of new m/c. - Tax shield lost on new m/c ie. -60000*35%= -21000 265000 265000 -1175000 -1175000 255000*(1-35%)*3.60478= 597492.3 117938*0.56743= 66921.56 -67680*35%*0.50663= -12001.1 Net present value of the decision -278587 IRR of the decision will be: -21000+265000-1175000+(255000*(1-35%)*(1-(1+r)^-5)/r)+(117938/(1+r)^5)-(67680*35%/(1+r)^6)=0 Irr= -ve r = -0.27% Replacing with new machine,with -ve NPV & -ve IRR , is not adding any value,so not recommendable. b. If expected life of existing machine decreased ,it will have further effect only upto the tax % *remaining book value ie.35%*60000=21000,in Year 0 ,on the cash flow & nothing further. c. If R&D were $30,000, it will have no effect on NPV---as it represents the amount already spent & nothing much can be done,so, will not be considered for NPV calculations.
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