Question
In: Finance
One year ago your company purchased a machine used in manufacturing for $90000, you can purchase...
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.
Solutions
Expert Solution
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
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