Question

The Woodruff Corporation purchased a piece of equipment three years ago for $245,000. It has an asset depreciation range (ADR) midpoint of eight years. The old equipment can be sold for $87,750.

A new piece of equipment can be purchased for $336,000. It also has an ADR of eight years.

Assume the old and new equipment would provide the following operating gains (or losses) over the next six years.

New Equipment	Old Equipment
$78,250	$24,000
$74,750	$17,000
$70,000	$8,000
$60,750	$6,500
$48,750	$5750
$45,250	$-6,500

The Firm has a 25% tax rate and a 9% cost of capital.

A. What is the net cost of the new equipment? (round 2 decimal places)

252702 - Correct

B. What is the present value of incremental benefits? (round 2 decimal places)

C. What is the NPV of this replacement decision? (round 2 decimal places)

Answer 1

Solution

Woodruff Corporation

a. Determination of the net cost of the new equipment:

Purchase price of new equipment                   $336,000

Less: sale value of old equipment                   ($87,750)

Net purchase cost of new equipment              $248,250

b. Determination of the present value of incremental benefits:

- Calculation of net income of new equipment

Year	Operating gain/(loss)	Tax at 25%	Net operating gain/(Loss)
1	$78,250	$19,562	$58,688
2	$74,750	$18,688	$56,062
3	$70,000	$17,500	$52,500
4	$60,750	$15,188	$45,562
5	$48,750	$12,188	$36,562
6	$45,250	$11,313	$33,937

Calculation of net income of old equipment:

Year	Operating gain/(loss)	Tax at 25%	Net operating gain/(Loss)
1	$24,000	$6,000	$18,000
2	$17,000	$4,250	$12,750
3	$8,000	$2,000	$6,000
4	$6,500	$1,625	$4,875
5	$5,750	$1,438	$4,312
6	($6,500)	+$1,625	($4,875)

Incremental net operating income/(loss):

Year	Net operating gain/(loss) of new equipment	Net operating gain/(loss) of old equipment	incremental net operating gain/(loss)	PV @ 9%	Present Value
1	$58,688	$18,000	$40,688	0.9174	$37,327.20
2	$56,062	$12,750	$43,312	0.8417	$36,456
3	$52,500	$6,000	$46,500	0.7722	$35,097.30
4	$45,562	$4,875	$40,687	0.7084	$28,823
5	$36,562	$4,312	$32,250	0.6499	$20,959
6	$33,937	($4,875)	$38,812	0.5963	$23,144.00
Total					$181,806

Present value of incremental benefits = $181,806

C. computation of the NPV of the replacement decision:

Net present value = present value of incremental benefits – present value of the net equipment cost

= 181,806 – 248,250 = ($66,444)

Net present value = ($66,444)

The net present value is negative. The replacement of the old equipment with new equipment is not profitable.