Question

Holmes Inc. purchased computer equipment two years ago at a total cost of $1,000,000. These computers could be sold today for $300,000. If these computers are sold in five years, they will be worth $50,000. The CCA rate for these computers is 30%.

         The company is now considering whether it should replace these computers with newer and more powerful ones. The estimated total purchase cost of the new computers is $1.5 million. These computers can be sold for $300,000 in five years, and their CCA rate remains at 30%. The company expects to obtain before-tax cost savings of $300,000 per year from these new computers.

         The company’s marginal tax rate is 35%, and its required rate of return on new equipment is 15%. Should the company replace the computer equipment?

Answer 1

Let's handle the cash flows due to sale of old computer.

Book value today = 1,000,000 x (1 - 30%)² =  490,000

Sale value = 300,000

Gain / (Loss) on sale = 300,000 - 490,000 = -190,000

Hence, post tax sale value = 300,000 - (-190,000) x 35% =  366,500

If it's sold after five years,

Book value = 1,000,000 x (1 - 30%)⁷ =   82,354.30

Sale value = 50,000

Gain / (Loss) on sale = 50,000 - 82,354.30 =  -32,354.30

Hence, post tax sale value = 50,000 - (-32,354.30) x 35% =   61,324.01

New computer:

Book value after 5 years = 1,500,000 x (1 - 30%)⁵ =  252,105

Sale value = 300,000

Gain / (Loss) on sale = 300,000 - 252,105 =  47,895

Hence, post tax sale value = 300,000 - 47,895 x 35% = 283,236.75

Incremental cash flows due to purchase of new computer:

Please see the table below. All financials are in $. Please see the second column titled "Linkage" to understand the mathematics. The last row colored in yellow contains your answer. Adjacent cell in blue shows the excel formula used to get the answer.

Since the NPV of the replacement porject is negative, hence the company should not replace the computer equipment.