Question

Pilot Plus Pens is deciding when to replace its old machine. The machine's current salvage value is $2.31 million. Its current book value is $1.51 million. If not sold, the old machine will require maintenance costs of $856,000 at the end of the year for the next five years. Depreciation on the old machine is $302,000 per year. At the end of five years, it will have a salvage value of $131,000 and a book value of $0. A replacement machine costs $4.41 million now and requires maintenance costs of $341,000 at the end of each year during its economic life of five years. At the end of the five years, the new machine will have a salvage value of $811,000. It will be fully depreciated by the straight-line method. Pilot will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 40 percent and the appropriate discount rate is 8 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation. Calculate the NPV for new and old machines.

Answer 1

The costs, cash flows and NPV for the old machine are :

depreciation tax shield per year = $302,000 * 40% - This is a net cash inflow since depreciation is a tax deductible expense. The tax savings due to depreciation is a cash inflow

net cash from sale of machine = (sale price - book value) * (1 - tax rate)

Net cash flow each year = maintenance costs + depreciation tax shield

the present value of each year's net cash flow is calculated using 8% discount rate. For example, present value of 3rd year's cash flow = $735,200 / (1.08^3)

The net cash receivable from sale of old machine = $2.31 million - ($2.31 million - $1.51 million)*40% = $1,990,000

NPV of old machine = $2,881,947 + $1,990,000 = $4,871,947

The costs, cash flows and NPV for the new machine are :

depreciation tax shield per year = ($4.41 million / 5) * 40% - This is a net cash inflow since depreciation is a tax deductible expense. The tax savings due to depreciation is a cash inflow

net cash from sale of machine = (sale price - book value) * (1 - tax rate)

Net cash flow each year = maintenance costs + depreciation tax shield

the present value of each year's net cash flow is calculated using 8% discount rate. For example, present value of 3rd year's cash flow = $11,800 / (1.08^3)

NPV of new machine = $378,286 + $4.410,000 = $4,788,286