Question

St. Johns River Shipyards' welding machine is 15 years old, fully depreciated, and has no salvage value. However, even though it is old, it is still functional as originally designed and can be used for quite a while longer. The new welder will cost $82,000 and have an estimated life of 8 years with no salvage value. The new welder will be much more efficient, however, and this enhanced efficiency will increase earnings before depreciation from $26,000 to $52,000 per year. The new machine will be depreciated over its 5-year MACRS recovery period, so the applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. The applicable corporate tax rate is 40%, and the project cost of capital is 15%. Should the old welder be replaced by the new one?

Answer 1

Time line		0	1	2	3	4	5	6	7	8
Cost of new machine		-82000
=Initial Investment outlay		-82000
5 years MACR rate			20.00%	32.00%	19.20%	11.52%	11.52%	5.76%	0.00%	0.00%
Profits			26000	26000	26000	26000	26000	26000	26000	26000
-Depreciation	=Cost of machine*MACR%		-16400	-26240	-15744	-9446.4	-9446.4	-4723.2	0	0
=Pretax cash flows			9600	-240	10256	16553.6	16553.6	21276.8	26000	26000
-taxes	=(Pretax cash flows)*(1-tax)		5760	-144	6153.6	9932.16	9932.16	12766.08	15600	15600
+Depreciation			16400	26240	15744	9446.4	9446.4	4723.2	0	0
=after tax operating cash flow			22160	26096	21897.6	19378.56	19378.56	17489.28	15600	15600
+Tax shield on salvage book value	=Salvage value * tax rate									5.821E-12
=Terminal year after tax cash flows										5.821E-12
Total Cash flow for the period		-82000	22160	26096	21897.6	19378.56	19378.56	17489.28	15600	15600
Discount factor=	(1+discount rate)^corresponding period	1	1.15	1.3225	1.520875	1.7490063	2.0113572	2.3130608	2.66001988	3.0590229
Discounted CF=	Cashflow/discount factor	-82000	19269.56522	19732.325	14398.027	11079.755	9634.5692	7561.0984	5864.617823	5099.6677
NPV=	Sum of discounted CF=	10639.63

Replace old welder as incremental NPV is positive