Question

The Woodruff Corporation purchased a piece of equipment three years ago for $230,000. It has an asset depreciation range (ADR) midpoint of eight years. The old equipment can be sold for $90,000.

A new piece of equipment can be purchased for $320,000. It also has an ADR of eight years.

Ye	New Equipment	Old Equipment                    Year
1	$80,000	$25,000                                  1
2	76,000	16,000                                   2
3	70,000	9,000                                      3
4	60,000	8,000                                     4
5	50,000	6,000                                      5
6	45,000	(7,000)                                    6

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

Question: The firm has a 25 percent tax rate and a 9 percent cost of capital. Should the new equipment be purchased to replace the old equipment? Explain your answer.

Answer 1

ADR %		Old eqpt.
14.29		1.BV (230000*43.73%)	100579
24.49		2.Sale value	90000
17.49	56.27	3.Loss on sale(1-2)	10579
12.49	43.73	4. Tax c/f saved on loss (3*25%)	2645
8.93		5.After-Tax salvage (2+4)	92645
8.92
8.93
4.46
100

Table-1	Opg. Gains/(loss)
Year	New Equipment	Old Equipment	After-tax gain=Diff*(1-25%)	PV F at 9%	PV at 9%
1	2	3	4=(2-3)*(1-25%)	5=1/1.09^Yr.n	6=4*5
1	80000	25000	41250	0.91743	37844
2	76,000	16000	45000	0.84168	37876
3	70,000	9000	45750	0.77218	35327
4	60,000	8000	39000	0.70843	27629
5	50,000	6000	33000	0.64993	21448
6	45,000	-7000	39000	0.59627	23254
					183378

Table-2	Tax shield
	Old m/c	ADR%*230000*25%	New m/c	ADR%*320000*25%	Diff. in T/Shield	PV F at 9%	PV at 9%
Year	ADR %		ADR %		(5-3)
1	12.49	7182	14.29	11432	4250	0.91743	3899
2	8.93	5135	24.49	19592	14457	0.84168	12168
3	8.92	5129	17.49	13992	8863	0.77218	6844
4	8.93	5135	12.49	9992	4857	0.70843	3441
5	4.46	2565	8.93	7144	4580	0.64993	2976
6			8.92	7136	7136	0.59627	4255
							33584

PV of after-tax salvage of Old equipment
92645*0.59627---------- (P/F,i=9%;n=6)	55241
Purchase cost of new m/c	-320000
PV of differential after-tax gain	183378
(As per Table -1)
PV of diffl.depn. Tax shield
(As per Table -2)	33584
NPV of the decision	-47797
As the NPV of the decision to buy new m/c is NEGATIVE, REPLACEMENT is NOT recommended.