Urban-Gym Inc.is considering purchasing new equipment to replace existing equipm

Question

Urban-Gym Inc.is considering purchasing new equipment to replace existing equipment that has book value of zero and market value of $75,000 today and is expected to be worthless in 10 years. New equipment costs $450,000 and is expected to provide production savings and increased profits of $100,000 per year for the next 10 years. New equipment has expected useful life of 10 years, after which its estimated salvage value would be $50,000.New equipment will be straight-line depreciated to zero in 10 years. Company’s effective tax rate is 35% and required rate of return is 10%. Should Urban-Tech Inc. replace the current equipment?

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Explanation / Answer

If the company decides to purchase the equipment today they need to pay 450,000 for equipment but they will also sell the old equipment and receive $75,000 which means they are paying 375,000 net. Annual savings will be $100,000 post tax i.e. 100,000* (1-0.35) = 65,000 and tax benefit on depreciation Annual depreciation will be (450,000-50,000)/10 = 40,000 Tax benefit on depreciation = 40,000*35% = $14,000. So, now we have annual savings of 65,000+14,000 = 79,000 for 10 years and then salvage value of 50,000 Also salvage value after tax will be 50,000*(1-0.35) = 32,500 Now, using financial calculator, we can calculate this by using following inputs N (number of years) 10 I/Y 10% Required rate of return PMT                79,000 Annual Savings Future Value                32,500 Savings from Salvage value Compute PV ($497,950.96) So we see that the present value of this equipment is about 498,000 where as the cost we need to pay is 375,000 Which means the benefit from this strategy is 498,000-375,000 = 123,000 almost. So, we will conclude that Urban tech should replace the equipment

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