Gluon Inc. is considering the purchase of a new high pressure glueball. It can p

Question

Gluon Inc. is considering the purchase of a new high pressure glueball. It can purchase the glueball for $60,000 and sell its old low-pressure glueball, which is fully depreciated, for $10,000. The new equipment has a 10-year useful life and will save $14,000 a year in expenses. The opportunity cost of capital is 11%, and the firm’s tax rate is 40%. What is the equivalent annual savings from the purchase if Gluon uses straight-line depreciation? Assume the new machine will have no salvage value.

Explanation / Answer

Operating Cash flow of new machine = (Revenues - Cash Expenses)*(1-Tax Rate) + (Tax Rate*Depreciation) (0-(-14000)*(0.60) + (0.40*(100000/10)) $12,400 NPV of new machine = Cost of new machine+After tax salvage value of old machine+operating cash flow*PVIFA11%,10 (60000)+(10000*0.6)+(12400*(1/0.11-(1/0.11*(1+0.11)^10))) (60000)+6000+(12400*5.889232) $19,026.48 Now we would calculate the annuity payment that has same NPV as the new machine purchase NPV = Annuity*PVIFA11%,10 $19026.48 = Annuity*((1/0.11-(1/0.11*(1+0.11)^10))) Annuity = $19026.48/5.889232 Annuity = $3230.723 Equivalent annual savings is $ 3230.723

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