Question

One year ago your company purchased a machine used in manufacturing for $90000, you can purchase it for $150,000 today. The CCA rate applicable to both machines is 30% and neither will have a long term salvage value. New machine will produce earnings before interest taxes depreciation and amortization of $35000 a year for the next 10 years. The current machine is expected to produce EBITDA of $21000 a year. Market value today of the current machine is 50000. The company’s tax rate is 40% and opportunity cost of capital 11%. Should the company replace the old machine and what is the NPV of the replacement.

Answer 1

This new machine SHOULD NOT be replaced, because NPV of replacement decision is negative.

NPV = - 20120.40

Step - 1 Compute the investment in Year = 0

Here we sell the old machine for 50000 and purchase the new machine for 150000. So additional funds needed = 150000 - 50000 = 100000. But old machine book value = 90000 - 30% = 63000. Selling this machine for 50000 = 63000 - 50000 = 13000 of loss.

Tax saved due this loss = 13000 * 0.40 = 5200

Net Investment at ,,,,,,,, t = 0 ,,,,,,,,,, = 150000 - 50000 - 5200 = 94800

Step - 2

Now calculate the annual cashflows for 1 to 10 years and NPV

	1	2	3	4	5	6	7	8	9	10
Increase in Revenue	14000	14000	14000	14000	14000	14000	14000	14000	14000	14000
(-) Increase in Depreciation	26100	18270	12789	8952.3	6266.61	4386.627	3070.639	2149.447	1504.613	1053.229
Profit before tax	-12100	-4270	1211	5047.7	7733.39	9613.373	10929.36	11850.55	12495.39	12946.77
(-) Tax	-4840	-1708	484.4	2019.08	3093.356	3845.349	4371.744	4740.221	4998.155	5178.708
Profit after tax	-7260	-2562	726.6	3028.62	4640.034	5768.024	6557.617	7110.332	7497.232	7768.063
(+) Depreciation	26100	18270	12789	8952.3	6266.61	4386.627	3070.639	2149.447	1504.613	1053.229
Cash flow after tax	18840	15708	13515.6	11980.92	10906.64	10154.65	9628.256	9259.779	9001.845	8821.292
Discounting factors	0.900901	0.811622	0.731191	0.658731	0.593451	0.534641	0.481658	0.433926	0.390925	0.352184
Present value of cash flows	16972.97	12748.97	9882.49	7892.203	6472.562	5429.091	4637.53	4018.063	3519.044	3106.722
Total of PV of cash flows	74679.64
Net Investment	94800
NPV	-20120.4

In the above table, depreciation calculation is the main aspect. CCA rate is given as 30%. The difference in book values of old machine and new machine = 150000 - 63000 = 87000

Year - 1 = 87000 * 0.3 = 26100

Year - 2 = 26100 * 0.70 = 18270

Under CCA method, depreciation continues to decrease year by year at a rate of..... ( 1 - depreciation)

So depreciation of any year = previous depreciation * 0.70