Question

Pilot Plus Pens is deciding when to replace its old machine. The machine's current salvage value is $2.21 million. Its current book value is $1.41 million. If not sold, the old machine will require maintenance costs of $846,000 at the end of the year for the next five years. Depreciation on the old machine is $282,000 per year. At the end of five years, it will have a salvage value of $121,000 and a book value of $0. A replacement machine costs $4.31 million now and requires maintenance costs of $331,000 at the end of each year during its economic life of five years. At the end of the five years, the new machine will have a salvage value of $801,000. It will be fully depreciated by the straight-line method. In five years a replacement machine will cost $3,210,000. The company will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 34 percent and the appropriate discount rate is 9 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation.

  

Calculate the NPV for the new and old machines.

Answer 1

NPV of the old machine

	1	2	3	4	5
Maintenance cost	-$8,46,000	-$8,46,000	-$8,46,000	-$8,46,000	-$8,46,000
Depreciation	-$2,82,000	-$2,82,000	-$2,82,000	-$2,82,000	-$2,82,000
after tax Salvage value					$79,860
Replacement cost					-$32,10,000
Net cash flows	-$11,28,000	-$11,28,000	-$11,28,000	-$11,28,000	-$42,58,140
Cost of capital	$0.917	$0.842	$0.772	$0.708	$0.650
PV of cash flows	-$10,34,862.4	-$9,49,415.0	-$8,71,023.0	-$7,99,103.6	-$27,67,498.8

NPV = sum of PV of cash flows = $6421902.85

Working notes

after tax salvage value = 121000*(1-0.34)

= $79,860

NPV of the new machine

	0	1	2	3	4	5
Maintenance cost		-$3,31,000	-$3,31,000	-$3,31,000	-$3,31,000	-$3,31,000
Depreciation		-$7,01,800	-$7,01,800	-$7,01,800	-$7,01,800	-$7,01,800
Salvage value of old machine	$19,38,000
Cost of machine	-$43,10,000
after tax Salvage value						$5,28,660
Net cash flows	-$23,72,000	-$10,32,800	-$10,32,800	-$10,32,800	-$10,32,800	-$5,04,140
Cost of capital	$1.000	$0.917	$0.842	$0.772	$0.708	$0.650
PV of cash flows	-$23,72,000.00	-$9,47,522.94	-$8,69,287.10	-$7,97,511.10	-$7,31,661.56	-$3,27,656.41

NPV = $60,45,639.10

Working notes>

1) Depreciation

Cost of machine	$43,10,000
salvage value	$8,01,000
Depreciable amount	$35,09,000
Depreciation	$7,01,800

2) After tax salvage of old machine

salvage value	$22,10,000
book value	$14,10,000
profit o n sale	$8,00,000
tax on profits	$2,72,000
After tax salvage value	$19,38,000

3) after tax salvage of new ,machine

= 801000*(1-0.34) = $5,28,660